Absorption Costing vs. Standard Costing

Attribute	Absorption Costing	Standard Costing
Definition	Includes all manufacturing costs (both variable and fixed) in the cost of a product	Uses predetermined costs for direct materials, direct labor, and overhead to calculate the cost of a product
Application	Used for external financial reporting	Used for internal management decision-making
Overhead Allocation	Allocates fixed overhead costs to products based on a predetermined rate	Allocates overhead costs based on standard rates and actual usage
Inventory Valuation	May result in higher inventory valuation due to inclusion of fixed overhead costs	May result in lower inventory valuation due to use of predetermined costs

Introduction

Costing is an essential aspect of managerial accounting that helps businesses determine the cost of producing goods or services. Two common costing methods used by businesses are absorption costing and standard costing. While both methods are used to calculate the cost of production, they have distinct attributes that set them apart. In this article, we will compare the attributes of absorption costing and standard costing to help businesses understand the differences between the two methods.

Definition

Absorption costing is a costing method that allocates all manufacturing costs to the cost of goods sold, including both variable and fixed costs. This method is required by generally accepted accounting principles (GAAP) for external financial reporting. On the other hand, standard costing is a costing method that assigns predetermined costs to products based on standard rates and quantities. This method is often used for internal management purposes to evaluate performance and control costs.

Cost Allocation

One of the key differences between absorption costing and standard costing is how costs are allocated to products. In absorption costing, all manufacturing costs, including direct materials, direct labor, and both variable and fixed overhead costs, are allocated to the cost of goods sold. This means that fixed overhead costs are included in the cost of each unit produced. On the other hand, standard costing only allocates predetermined costs to products based on standard rates and quantities. This allows for better cost control and performance evaluation.

Inventory Valuation

Another important difference between absorption costing and standard costing is how inventory is valued. In absorption costing, fixed manufacturing overhead costs are included in the cost of inventory. This means that the value of inventory includes both variable and fixed manufacturing costs. On the other hand, standard costing values inventory based on predetermined costs, which may not reflect the actual costs incurred. This can lead to variances between actual and standard costs.

Cost Variance Analysis

Cost variance analysis is a key tool used in both absorption costing and standard costing to evaluate performance and control costs. In absorption costing, cost variances are calculated by comparing actual costs to budgeted costs. This helps businesses identify areas where costs are higher or lower than expected. On the other hand, standard costing uses predetermined costs as a benchmark for evaluating performance. Variances are calculated by comparing actual costs to standard costs, allowing businesses to identify inefficiencies and take corrective actions.

Flexibility

One of the advantages of standard costing over absorption costing is its flexibility. Standard costing allows businesses to easily update standard costs to reflect changes in the cost of inputs or production processes. This flexibility makes it easier for businesses to adapt to changing market conditions and improve cost control. On the other hand, absorption costing relies on actual costs, which may not be as easily adjusted. This can make it more challenging for businesses to respond to changes in the cost of production.

Decision Making

When it comes to decision making, absorption costing and standard costing can provide different insights. Absorption costing provides a more accurate reflection of the total cost of production, including fixed overhead costs. This can be useful for pricing decisions and determining the profitability of products. On the other hand, standard costing focuses on predetermined costs, which may not always reflect the actual costs incurred. This can lead to decisions based on outdated or inaccurate cost information.

Conclusion

In conclusion, absorption costing and standard costing are two common costing methods used by businesses to calculate the cost of production. While both methods have their advantages and disadvantages, understanding the attributes of each method is essential for businesses to make informed decisions about cost control, performance evaluation, and pricing. By comparing the attributes of absorption costing and standard costing, businesses can choose the method that best suits their needs and helps them achieve their financial goals.