Absorption Costing vs. Variable Costing

Attribute	Absorption Costing	Variable Costing
Definition	Includes all manufacturing costs, both fixed and variable, in the cost of a product	Includes only variable manufacturing costs in the cost of a product
Treatment of Fixed Costs	Fixed costs are allocated to products based on a predetermined overhead rate	Fixed costs are not allocated to products, they are treated as period expenses
Inventory Valuation	Fixed and variable manufacturing costs are included in the valuation of inventory	Only variable manufacturing costs are included in the valuation of inventory
Profit Calculation	May result in higher reported profits when production exceeds sales	May result in lower reported profits when production exceeds sales
Cost Behavior	Costs are classified as either fixed or variable	Costs are classified as either fixed or variable
Decision Making	May lead to suboptimal decisions due to the allocation of fixed costs	May provide more accurate information for decision making

Introduction

Costing methods play a crucial role in determining how a company allocates and tracks its costs. Two commonly used methods are absorption costing and variable costing. 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.

Definition and Calculation

Absorption costing, also known as full costing, considers all manufacturing costs, both variable and fixed, as part of the cost of producing a product. It allocates fixed manufacturing overhead costs to units of production based on a predetermined rate. The formula for absorption costing is:

Total Cost per Unit = (Direct Materials + Direct Labor + Variable Manufacturing Overhead + Fixed Manufacturing Overhead) / Total Units Produced

On the other hand, variable costing, also known as direct costing or marginal costing, only considers variable manufacturing costs as part of the cost of producing a product. Fixed manufacturing overhead costs are treated as period expenses and are not allocated to units of production. The formula for variable costing is:

Total Cost per Unit = (Direct Materials + Direct Labor + Variable Manufacturing Overhead) / Total Units Produced

Allocation of Fixed Manufacturing Overhead

One of the key differences between absorption costing and variable costing lies in the allocation of fixed manufacturing overhead costs. 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.

On the other hand, variable costing treats fixed manufacturing overhead costs as period expenses. These costs are not allocated to units of production but are expensed in the period they are incurred. Consequently, variable costing only includes variable manufacturing costs in the cost of each unit produced. This approach can result in lower per-unit costs compared to absorption costing.

Impact on Inventory Valuation

The different treatment of fixed manufacturing overhead costs in absorption costing and variable costing also affects the valuation of inventory. Under absorption costing, fixed manufacturing overhead costs are included in the cost of inventory, whether it is finished goods, work-in-progress, or raw materials. This means that fixed manufacturing overhead costs are carried forward in inventory until the goods are sold. As a result, the value of inventory under absorption costing is higher compared to variable costing.

Conversely, variable costing only includes variable manufacturing costs in the cost of inventory. Fixed manufacturing overhead costs are expensed in the period they are incurred and do not impact the valuation of inventory. Therefore, the value of inventory under variable costing is lower compared to absorption costing.

Impact on Profitability Analysis

The choice between absorption costing and variable costing can also have implications for profitability analysis. Since absorption costing includes fixed manufacturing overhead costs in the cost of each unit produced, it tends to result in higher reported profits when sales volume exceeds production volume. This is because fixed manufacturing overhead costs allocated to inventory are released as expenses when the goods are sold, increasing the profit margin.

On the other hand, variable costing only includes variable manufacturing costs in the cost of each unit produced. As a result, reported profits under variable costing are not influenced by changes in inventory levels. This can provide a clearer picture of the profitability of a company's operations, especially when inventory levels fluctuate significantly.

Decision-Making Implications

The choice between absorption costing and variable costing can have significant implications for decision-making within an organization. Absorption costing may be more suitable for companies that have a high proportion of fixed manufacturing overhead costs and stable inventory levels. It provides a comprehensive view of the cost of production and can help in setting appropriate selling prices to cover all costs.

On the other hand, variable costing may be more appropriate for companies that experience significant fluctuations in inventory levels or have a high proportion of variable manufacturing costs. It allows for better cost control and can provide more accurate information for decision-making, such as determining the profitability of specific product lines or evaluating the impact of changes in production volume.

Conclusion

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. It values inventory at a lower level and provides a clearer picture of profitability. The choice between absorption costing and variable costing depends on the nature of the business, the stability of inventory levels, and the desired level of cost control and decision-making accuracy.