What Are the Differences between Variable and Absorption Costing?
Variable and absorption costing are two allocation methods that companies use to determine product cost. Each has significant differences in how they allocate manufacturing overhead. Variable costing only applies the variable manufacturing overhead costs. Absorption costing applies all manufacturing overhead costs, both fixed and variable. Direct material and direct labor allocation is the same for both methods; differences occur in income reporting, product pricing, and decision making.
Both of these costing methods fall under accrual accounting procedures. All costs get recorded as a company incurs them, regardless if cash changes hands or not. Fixed costs do not change in a production system regardless of output. Variable costing requires companies to expense fixed costs in the accounting period when they occur. The absorption method, however, adds fixed costs to the production system, ultimately allocating the costs to manufactured products.
Income reporting is one major difference between these two costing methods. Under the process described earlier, variable costing reports lower net income. This occurs because companies expense fixed costs, while absorption costing does not. Lower profit on the income statement reduces taxes paid by the company. Companies using the absorption method will not incur lower net income until they sell goods, which move the costs from inventory to cost of goods sold.
Product cost information is another significant difference. The variable method has a tendency to undercost manufactured goods because a company does not record fixed manufacturing overhead to products. Absorption cost principles seek a more defined product cost. Including all manufacturing overhead — fixed and variable — gives companies a more accurate description of costs needed to produce goods.
Another different is in pricing products. Companies that use variable costing may think they can price products lower than those using the absorption method, but this is untrue. Reducing the final selling price will result in lower net income because fixed manufacturing overhead resides as a period cost on the income statement. Companies need to ensure that they price goods appropriately to cover all product costs, whether on the income statement or included as the inventory cost.
Managerial decisions may also be different under each method. One issue, for example, is to select which method provides the most accurate product cost and meets accounting guidelines. National accounting standards may not approve of variable costing. Therefore, managers must determine which method their company should use. Another decision is how production output affects fixed costs, which can change on a per-unit basis when manufacturing goods.
@David09 - Well, if national accounting standards may not endorse the variable costing method, there is a reason that they don’t. The whole thing sounds shady to me, like you’re trying to bury some of your numbers that would impact your bottom line. I say put everything out there and there should be no surprises.
@everetra - I tend to agree with the economics professor you cite. There must have been some reason he became a renowned economist so I believe I’m in good company.
Absorption costing may seem to make the most sense, but I think the fixed costs become less relevant over time. Why is that? Because you reach a point that with each unit cost, it becomes cheaper and cheaper to make the unit.
In other words, your machines and output are at maximum capacity. The fixed costs become less and less important at that point.
@everetra - I believe that absorption costing makes the most sense, because it includes all the costs involved. Why would you omit part of your costs in determining how to price your product?
Some people might think that the fixed costs would skew the real costs of production, but I think the opposite is true. You never want to underestimate your real costs, and therefore inflate your profit figures.
I think you should stay conservative in your accounting estimates and normal absorption costing would lead you to safe numbers, I think.
I took an economics course in college taught by a renowned economist. I don’t remember a whole lot that he taught, but I do remember this distinction about activity based costing.
He seemed to favor the variable costing method, if I recall his words correctly. He said that a fixed cost is a “sunk cost.” You don’t need to include it again in your pricing of the product.
I remember that idea was somewhat counterintuitive to me and it still is, even to this today. I took the notes from my class to my dad, who was an accountant at the time and who helped me in economics, and he vehemently disagreed with the guy.
My dad was a believer in full absorption costing.
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