Knowledge about the difference between absorption costing and variable costing is a must to do the product costing. Actually, success of a manufacturing business mainly depends on the way that the products are cost. There are different types of costs involved in a manufacturing environment. Particularly, the costs can be identified as variable costs and fixed costs. Absorption costing and variable costing are two different costing approaches used by manufacturing organizations. This difference occurs as absorption costing treats all variable and fixed manufacturing costs as product cost while variable costing treats only the costs that vary with the output as product cost. An organization cannot practice both the approaches at the same time while the two methods, absorption costing and variable costing, carry their own advantages and disadvantages.
What is Absorption Costing?
Absorption costing, which is also known as full costing or traditional costing, captures both fixed and variable manufacturing costs into the unit cost of a particular product. Therefore, the cost of a product under absorption costing consists of direct material, direct labour, variable manufacturing overhead, and a portion of a fixed manufacturing overhead absorbed using an appropriate base.
Since absorption costing takes all the potential costs into accounts in the calculation of per unit cost, some people believe that it is the most effective method to calculate the unit cost. This approach is simple. Moreover, under this method the inventory carries a certain amount of fixed expenses, so by showing a highly valued closing inventory, the profits for the period will also be improved. However, this can be used as an accounting trick to show the higher profits for a particular period by moving fixed manufacturing overhead from the income statement to the balance sheet as closing stocks.
What is Variable Costing?
Variable costing, which is also known as direct costing or marginal costing considers only the direct costs as the product cost. Thus, the cost of a product consists of direct material, direct labour and the variable manufacturing overhead. Fixed manufacturing overhead is considered as a periodic cost similar to the administrative and selling costs and charged against the periodic income.
Variable costing generates a clear picture on how the cost of a product changes in an incremental manner with the change in level of output of a manufacturer. However, since this method does not consider the overall manufacturing costs in costing its products, it understates the overall cost of the manufacturer.
The similarity between Absorption Costing and Variable Costing is that the purpose of both approaches are the same; to value the cost of a product.
What is the difference between Absorption Costing and Variable Costing?
• Absorption Costing charges all the manufacturing costs into the cost of a product. Variable costing charges only direct costs (material, labour and variable overhead costs) into the cost of a product.
• Product cost in absorption costing is higher than the cost calculated under variable costing. In variable costing, cost of the product is lower than the cost calculated under absorption costing.
• Value of closing stocks (in the income statement and balance sheet) is higher under absorption costing method. In variable costing, value of closing stocks is lower compared to absorption costing.
• In the absorption costing, fixed manufacturing overhead is considered as a unit cost and charged against the selling price. In variable costing, fixed manufacturing overhead is considered as a periodic cost and charged from the periodic gross profits.
Summary:
Absorption Costing vs Variable Costing
Absorption Costing and Variable Costing are two main approaches used by manufacturing organizations to arrive at cost per unit for various decision making purposes. Absorption costing considers that all the manufacturing costs should be included in per unit cost of a product; thus other than direct costs it adds a portion of fixed manufacturing cost to calculate product cost. In contrast, variable costing considers mere direct (variable) costs as product cost. Therefore, two approaches provide two product cost figures. Having understood their own advantages and disadvantages, both methods can be used as effective pricing approaches by the manufacturers.