Question

What is the difference between absorption and variable costing and why does inventory level which is reported on the Balance Sheet affect net income which is reported on the Income Statement? How is the accounting definition of an asset related to the decision to use absorption vs. variable costing?

Answer 1

Absorption costing takes into account all the cost incurred during the manufacturing process of an an orgsnization, it even includes fixed cost. All these costs are added and then assigned to individual product .

Whereas in variable costing only variable cost of production are taken into account. Fixed cost are not assigned to an individual product.

Due to the involvement if fixed cost in absorption costing , it shows true picture of all the cost incurred and shows true cost of a product and that's why it's being accepted by USGAAP.

whereas variable costing generally ignores fixed Cost and is also not acceptable by USGAAP.

Note that the purpose of reporting inventory in balance sheet and income statement is entirely different. In balancehseet we only show the ending balance of inventory as an asset whereas in income statement in order to find out the cost of goods sold it is important to inculcate both beginning inventory and ending inventory . When we add beginning inventory to the purchases made during the year and deduct from them the ending inventory remaining, it will give us cost of goods sold. That's why inventory which is reported on balancehseet also affects net income which is reported on the balance sheet.