Absorption costing is a method of costing in which fixed costs are treated as a product cost and assigned to the units produced.

Fixed costs follow the units through work-in-process and finished goods as an inventoriable cost and are expensed through cost of goods sold when the units are sold.

Absorption costing is required by GAAP for external reporting and by the IRS for tax purposes. Variable costing is often used for internal purposes.

Absorption costing does not always give the same net income as variable costing:

If production equals sales, then absorption profit equals variable profit.

If production is greater than sales, then absorption profit is greater than variable profit.

If production is less than sales, then absorption profit is less than variable profit.

If production fluctuates and sales are constant, then absorption profit fluctuates and variable profit is constant.

If production is constant and sales fluctuate, then both absorption profit and variable profit vary in the direction of sales.

The central issue that distinguishes variable from absorption costing is the question of the timing of the recognition of fixed costs as an expense—variable costing recognizes these costs as incurred while absorption costing recognizes these costs when the goods are sold.

Difference in Profits = Fixed OH/Unit x Change in Inventory (units)

Absorption costing does not give exactly the same results in all entities due to other differences in inventory costing (LIFO, FIFO, weighted average) and differences in overhead application.