Definition
Variable costing, also known as direct costing, includes only variable manufacturing costs such as direct materials and direct labor in the cost of goods sold. On the other hand, absorption costing, also known as full costing, incorporates all manufacturing costs, variable and fixed, into the cost of goods sold. The main difference lies in how they handle fixed manufacturing overhead costs, with variable costing treating these as period costs and absorption costing treating them as product costs.
Key Takeaways
- Variable Costing considers only variable costs – costs that vary with the level of output – in product cost calculation. In contrast, Absorption Costing takes into account all the costs associated with production that includes both variable costs and a portion of fixed costs.
- The main difference between the two cost calculation methods lies in the handling of fixed manufacturing overhead costs. In Variable Costing these costs are treated as period costs and are charged to income statement at once, while in Absorption Costing these costs are absorbed into the product and thus part of the cost becomes inventory asset.
- Because of the differences in cost accounting, the choice between Variable Costing and Absorption Costing could lead to different product pricing and business decisions. Using Absorption Costing could allow companies to inflate their profit levels by producing more. On the other hand, Variable Costing shows only the true per-unit cost of production therefore could result in less distortion of cost data.
Importance
Understanding the difference between variable costing and absorption costing is crucial in business as it impacts profit measurement and management decision making.
Variable costing, also known as direct costing, only considers costs that vary with production volumes such as direct materials and direct labor in product costing, thus it provides a clearer picture of the incremental cost of producing each additional unit.
On the other hand, absorption costing, also known as full costing, takes into account all production costs, both variable and fixed, attributing them to the product.
This method offers a comprehensive view of the total cost to produce a product, which aids in pricing decisions, profitability analysis and financial reporting.
Therefore, the choice between these two methods significantly affects a company’s reported profit, inventory valuation, and understanding of costs behavior, and can thereby influence managerial decisions related to budgeting, production planning, and performance evaluation.
Explanation
Variable costing and absorption costing are two different methods used for accounting the costs of producing a product or service. The main difference between them refers to the way they deal with fixed overhead costs. Variable costing, also known as direct costing, includes only variable production costs- such as materials, labor, and utility bills- in product costs.
Its main purpose is to allow management to understand how changes in volume affect profitability. The method is particularly useful for short-term financial decisions as it treats fixed costs as period costs, and provides insights on cost control and performance. Absorption costing, on the other hand, considers all production costs, both variable and fixed, as product costs.
It is used for accurately calculating the true total production cost per unit, giving managers a more thorough picture of cost per product. Therefore, it is typically used for long-term pricing decisions. By using absorption costing, businesses can ensure that all costs are covered in the price they are charging for their products or services.
Examples of Variable Costing vs Absorption Costing
Manufacturing Industry: In a car manufacturing company, the variable cost includes the cost of materials like metal, glass, plastic, etc. and direct labor which vary with the number of cars produced. On the other hand, the absorption cost includes both variable costs and fixed costs like rent of the factory, utilities, salaries of permanent employees, etc., which are incurred irrespective of the number of cars manufactured.
Hospitality Industry: A hotel incurs variable costs for things like food and beverages, cleaning supplies, and wages for part-time staff which are directly related to the number of guests. Meanwhile, its absorption costs will include both these variable costs and fixed costs like property rent, electricity, and salaries of full-time employees which need to be paid regardless of the occupancy rate.
E-commerce: An e-commerce company might have variable costs that fluctuate based on the number of goods sold, such as packaging and shipping costs. Absorption costing, however, would also include fixed costs such as website maintenance, salaries of IT support, and the cost of running the company’s offices, which the company incurs regardless of the number of goods sold.
FAQs about Variable Costing vs Absorption Costing
What is Variable Costing?
Variable costing, also known as direct costing, is a costing method where only variable manufacturing costs are included as the product’s cost. These costs include direct materials, direct labor, and variable manufacturing overheads.
What is Absorption Costing?
Absorption costing, on the other hand, includes both variable and fixed manufacturing costs in the product’s cost. It refers to the method that attributes all manufacturing costs to the product, regardless of their nature.
What are the main differences between Variable Costing and Absorption Costing?
The main differences between these two costing methods lie in the way they treat fixed manufacturing overhead costs. In variable costing, these costs are treated as period costs and are expensed out when they are incurred. In contrast, absorption costing treats them as product costs and assigns them to each unit of product manufactured, to be expensed when the product is sold.
What are the advantages of Variable Costing?
Variable costing offers a number of advantages. It provides a clearer picture of the actual contribution margin of each product, helps to avoid product cost distortion arising from variations in output levels, and is more useful for short-term decision-making and cost control.
What are the advantages of Absorption Costing?
Absorption costing, in contrast, is seen as more beneficial for long-term pricing decisions because it takes into account all production costs. It is also the method required for external financial reporting and tax purposes in many jurisdictions.
Related Entrepreneurship Terms
- Contribution Margin
- Fixed and Variable Costs
- Inventory Valuation
- Product Pricing
- Cost-Volume-Profit Analysis
Sources for More Information
- Investopedia: Provides broad range of information related to finance and business concepts including variable costing vs absorption costing.
- Accounting Tools: A website dedicated to accounting principles and methods.
- Corporate Finance Institute: Offers detailed courses and free resources on a variety of finance topics, including costing methods.
- My Accounting Course: Provides comprehensive details about both Variable Costing and Absorption Costing.
