Absorption costing vs Variable costing:

Learning Objectives:

1. Define and explain variable and absorption costing.
2. Explain the difference between variable and absorption costing and calculate unit product cost under each method.

Absorption Costing or Full Costing System:

Definition and explanation:

Absorption costing is a costing system which treats all costs of production as product costs, regardless weather they are variable or fixed. The cost of a unit of product under absorption costing method consists of direct materials, direct labor and both variable and fixed overhead. Absorption costing allocates a portion of fixed manufacturing overhead cost to each unit of product, along with the variable manufacturing cost. Because absorption costing includes all costs of production as product costs, it is frequently referred to as full costing method.

Variable, Direct or Marginal Costing:

Definition and explanation:

Variable costing is a costing system under which those costs of production that vary with output are treated as product costs. This would usually include direct materials, direct labor and variable portion of manufacturing overhead. Fixed manufacturing cost is not treated as a product costs under variable costing. Rather, fixed manufacturing cost is treated as a period cost and, like selling and administrative expenses, it is charged off in its entirety against revenue each period. Consequently the cost of a unit of product in inventory or cost of goods sold under this method does not contain any fixed overhead cost. Variable costing is some time referred to as direct costing or marginal costing. To complete this summary comparison of absorption and variable costing, we need to consider briefly the handling of selling and administrative expenses. These expenses are never treated as product costs, regardless of the costing method in use. Thus under either absorption or variable costing, both variable and fixed selling and administrative expenses are always treated as period costs and deducted from revenues as incurred.

The concepts explained so for are illustrated below

Unit Cost Computation/Calculation:

To illustrate the computation/calculation of unit product costs under both absorption and variable costing consider the following example.

 Example:

A small company that produces a single product has the following cost structure.

Required:

1. Compute the unit product cost under absorption costing method.
2. Compute the unit product cost under variable / marginal costing method.

Under the absorption costing, notice that all production costs, variable and fixed, are included when determining the unit product cost. Thus if the company sells a unit of product and absorption costing is being used, then $12 (consisting of $7 variable cost and $5 fixed cost) will be deducted on the income statement as cost of goods sold. Similarly, any unsold units will be carried as inventory on the balance sheet at $12 each.

Under variable costing, notice that all variable costs of production are included in product costs. Thus if the company sells a unit of product, only $7 will be deducted as cost of goods sold, and unsold units will be carried in the balance sheet inventory account at only $7.

You may also be interested in other articles from “variable costing system” chapter

1. Variable Costing Vs Absorption Costing
2. Income Comparison of Variable and Absorption Costing
3. Advantages and Disadvantages of Absorption Costing
4. Limitations of variable costing – GAAP and External Reports
5. Advantages of Variable Costing
6. Variable Costing and Theory of Constraints
7. Impact of Just In Time (JIT) Inventory Methods
8. Variable | Direct Costing and Absorption Costing Discussion Questions and Answers