How do inventory levels impact absorption costing?

1 Inventory and cost of goods sold

The cost of goods sold (COGS) is the amount of money spent to produce and sell the products that generate revenue. Under absorption costing, COGS includes both variable and fixed costs, while under variable costing, it only includes variable costs. This means that under absorption costing, COGS is lower when inventory increases and higher when inventory decreases, compared to variable costing. Why is that? Because when inventory increases, some of the fixed costs are deferred to the balance sheet as part of the inventory value, and when inventory decreases, some of the fixed costs are released to the income statement as part of COGS.

2 Inventory and gross profit

The gross profit is the difference between the revenue and the COGS. Under absorption costing, gross profit is higher when inventory increases and lower when inventory decreases, compared to variable costing. Why is that? Because when inventory increases, COGS is lower, and when inventory decreases, COGS is higher, as explained above. This means that under absorption costing, gross profit is affected by the changes in inventory levels, while under variable costing, it is not.

3 Inventory and net income

The net income is the difference between the gross profit and the operating expenses. Operating expenses are those that are not directly related to the production and sale of the products, such as marketing and administration. Under absorption costing, operating expenses include only variable costs, while under variable costing, they include both variable and fixed costs. This means that under absorption costing, operating expenses are lower than under variable costing, regardless of the inventory levels. However, this does not necessarily mean that net income is higher under absorption costing, because it depends on the effect of inventory changes on gross profit, as explained above. Therefore, under absorption costing, net income is higher when inventory increases and lower when inventory decreases, compared to variable costing, assuming that revenue and operating expenses remain constant.

4 Inventory and break-even point

The break-even point is the level of output or sales that results in zero net income, meaning that revenue equals total costs. Under absorption costing, the break-even point is lower than under variable costing, because the fixed costs are spread over more units of output or sales, reducing the average cost per unit. However, this also means that under absorption costing, the break-even point is affected by the changes in inventory levels, while under variable costing, it is not. Therefore, under absorption costing, the break-even point is lower when inventory increases and higher when inventory decreases, compared to variable costing.

5 Inventory and performance evaluation

One of the implications of absorption costing is that it can create incentives or disincentives for managers to manipulate inventory levels to influence the reported net income. For example, if managers are evaluated based on net income, they might increase inventory at the end of a period to defer some of the fixed costs and boost net income, or they might decrease inventory to release some of the fixed costs and reduce net income, depending on their goals and expectations. This can distort the true profitability and efficiency of the operations and create conflicts between managers and shareholders. Therefore, it is important to use other measures of performance, such as return on investment, cash flow, or variable costing income, to complement absorption costing income and avoid inventory-related biases.

6 Inventory and decision making

Another implication of absorption costing is that it can affect the decision making process of managers regarding the optimal level of output, pricing, and product mix. For example, if managers use absorption costing to determine the product cost and the selling price, they might overestimate or underestimate the contribution margin of each product, depending on the inventory level. The contribution margin is the difference between the selling price and the variable cost per unit, and it represents the amount of money that each unit contributes to cover the fixed costs and generate profit. Under absorption costing, the contribution margin is higher when inventory increases and lower when inventory decreases, compared to variable costing. This can lead to suboptimal decisions, such as producing more than the market demand, underpricing or overpricing the products, or favoring less profitable products over more profitable ones. Therefore, it is advisable to use variable costing to calculate the contribution margin and the break-even point, and to consider the opportunity cost and the relevant cost of each decision, rather than the absorption cost.

7 Here’s what else to consider

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