In conclusion, absorption costing and variable costing are two distinct methods of cost allocation that differ in their treatment of fixed manufacturing overhead costs. Absorption costing includes fixed manufacturing overhead costs in the cost of each unit produced and values inventory at a higher level. It can result in higher reported profits when sales volume exceeds production volume. On the other hand, variable costing treats fixed manufacturing overhead costs as period expenses and only includes variable manufacturing costs in the cost of each unit produced.

The accountant’s entire business organization needs to understand that the costing system is created to provide efficiency in assisting in making business decisions. Determining the appropriate costing system and the type of information to be provided to management goes beyond providing just accounting information. The costing system should provide the organization’s management with factual and true financial information regarding the organization’s operations and the performance cost principle example of the organization. Unethical business managers can game the costing system by unfairly or unscrupulously influencing the outcome of the costing system’s reports. Keep in mind, companies using the cash method may not need to recognize some of their expenses as immediately with variable costing since they are not tied to revenue recognition. Whichever costing method a company selects to use for accounting purposes, there are advantages and disadvantages.

In addition to the fixed manufacturing overhead costs, absorption costing also includes the variable manufacturing costs in the cost of a product. These costs are directly traceable to a specific product and include direct materials, direct labor, and variable overhead. Variable costing only includes the product costs that vary with output, which typically include direct material, direct labor, and variable manufacturing overhead. Fixed manufacturing overhead is still expensed on the income statement, but it is treated as a period cost charged against revenue for each period. It does not include a portion of fixed overhead costs that remains in inventory and is not expensed, as in absorption costing.

Costing methods play a crucial role in determining how a company allocates and tracks its costs. While both methods aim to calculate the cost of producing goods or services, they differ in their approach to allocating fixed manufacturing overhead costs. In this article, we will explore the attributes of absorption costing and variable costing, highlighting their differences and potential implications for decision-making.

Companies that use variable costing keep fixed-cost operating expenses separate from production costs. Carrying over inventories and overhead costs is reflected in the ending inventory balances at the end of the production period, which become the beginning inventory balances at the start of the next period. It is anticipated that the units that were carried over will be sold in the next period. If the units are not sold, the costs will continue to be included in the costs of producing the units until they are sold. Finally, at the point of sale, whenever it happens, these deferred production costs, such as fixed overhead, become part of the costs of goods sold and flow through to the income statement in the period of the sale. This treatment is based on the expense recognition principle, which is one of the cornerstones of accrual accounting and is why the absorption method follows GAAP.

For example, a company has to pay its manufacturing property mortgage payments every month regardless of whether it produces 1,000 products or no products at all. A company may see an increase in gross profit after paying off a mortgage or finishing the depreciation schedule on a piece of manufacturing equipment. These are considerations cost accountants must closely manage when using absorption costing. Absorption costing also provides a more accurate accounting of net profitability, especially when a company doesn’t sell all of its products in the same accounting period in which they are manufactured. The disadvantages of absorption costing are that it can skew the picture of a company’s profitability. In addition, it is not helpful for analysis designed to improve operational and financial efficiency, or for comparing product lines.

Disadvantages of Absorption Costing

Absorption costing allocates these costs to units of production, regardless of whether they are sold or remain in inventory. This means that fixed manufacturing overhead costs are included in the cost of each unit produced, whether it is sold or not. As a result, absorption costing tends to have higher per-unit costs compared to variable costing. Under absorption costing, each unit in ending inventory carries $0.60 of fixed overhead cost as part of product cost. Therefore, ending inventory under absorption costing includes $600 of fixed manufacturing overhead costs ($0.60 X 1,000 units) and is valued at $600 more than under variable costing. The difference between the absorption and variable costing methods centers on the treatment of fixed manufacturing overhead costs.

Inventory Differences

Though variable costing aids in managerial decisions, it should not be the sole basis. The management should look at different perspectives, including absorption costing data. The management should look at consumer insights, relation with buyers, the effect on brand-building, and other factors while making decisions. Even if a company chooses to use variable costing for in-house accounting purposes, it still has to calculate absorption costing to file taxes and issue other official reports.

1. These costs include raw materials, labor, and any other direct expenses that are incurred in the production process.
2. Figure 6.13 shows the cost to produce the 8,000 units of inventory that became cost of goods sold and the 2,000 units that remain in ending inventory.
3. Variable selling and administrative expenses are not part of product cost under either method.
4. While both methods are used to calculate the cost of a product, they differ in the types of costs that are included and the purposes for which they are used.

Impact on Profitability Analysis

For example, assume a new company has fixed overhead of $12,000 and manufactures 10,000 units. Direct materials cost is $3 per unit, direct labor is $15 per unit, and the variable manufacturing overhead is $7 per unit. Under absorption costing, the amount of fixed overhead in each unit is $1.20 ($12,000/10,000 units); variable costing does not include any fixed overhead as part of the cost of the product. Figure 6.11 shows the cost to produce the 10,000 units using absorption and variable costing.

Variable vs Absorption Costing Comparative Table

Under absorption costing, the 2,000 units in ending inventory include the $1.20 per unit share, or $2,400 of fixed cost. That cost will be expensed when the inventory is sold and accounts for the difference in net income under absorption and variable costing, as shown in Figure 6.14. Indirect costs are those costs that cannot be directly traced to a specific product or service. These costs are also known as overhead expenses and include things like utilities, rent, and insurance. Indirect costs are typically allocated to products or services based on some measure of activity, such as the how to get started with payroll in xero number of units produced or the number of direct labor hours required to produce the product. Direct costs are those costs that can be directly traced to a specific product or service.

Although any company can use both methods for different reasons, public companies are required to use absorption costing due to their GAAP accounting obligations. Companies must choose between absorption costing or variable costing in their accounting systems, and there are advantages and disadvantages to either choice. Absorption costing, or full absorption costing, captures all of the manufacturing or production costs, such as direct materials, direct labor, rent, and insurance. The fixed costs that differentiate variable and absorption costing are primarily overhead expenses, such as salaries and building leases, that do not change with changes in production levels.

This makes it more difficult for management to make the best decisions for operational efficiency. Advocates of absorption costing argue that fixed manufacturing overhead costs are essential to the production process and are an actual cost of the product. They further argue that costs should be categorized by function rather than by behavior, and these costs must be included as a product cost regardless of whether the cost is fixed or variable.

The reason variable costing isn’t allowed for external reporting is because it doesn’t follow the GAAP matching principle. It fails to recognize certain inventory costs in the same period in which revenue is generated by the expenses, like fixed overhead. In contrast to the variable costing method, every expense is allocated to manufactured products, whether or not they are sold by the end of the period. What’s more, for external reporting purposes, it may be required because it’s the only method that complies with GAAP. The absorption costing method is typically the standard for most companies with COGS. Depending on the type of business structure, small businesses may also be required to use absorption costing for their tax reporting.

Consequently, variable costing only includes variable manufacturing costs in the cost of each unit produced. Under absorption costing, the fixed manufacturing overhead costs are included in the cost of a product as an indirect cost. These costs are not directly traceable to a specific product but are incurred in the process of manufacturing the product.

Absorption costing is used to determine the cost of goods sold and ending inventory balances on the income statement and balance sheet, respectively. It is also used to calculate the profit margin on each unit of product and to determine the selling price of the product. Because absorption costing defers costs, the ending inventory figure differs from that calculated using the variable costing method. As shown in Figure 6.13, the inventory figure under absorption costing considers both variable and fixed manufacturing costs, whereas under variable costing, it only includes the variable manufacturing costs.