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Variable Costing Vs Absorption Costing

Variable costing and absorption costing differ primarily in the treatment of fixed manufacturing costs, with variable costing treating them as period costs and absorption costing as product costs. Variable costing is useful for internal decision-making, while absorption costing is required for external financial reporting. Additionally, inventory valuation and profit fluctuations vary significantly between the two methods.

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1 views3 pages

Variable Costing Vs Absorption Costing

Variable costing and absorption costing differ primarily in the treatment of fixed manufacturing costs, with variable costing treating them as period costs and absorption costing as product costs. Variable costing is useful for internal decision-making, while absorption costing is required for external financial reporting. Additionally, inventory valuation and profit fluctuations vary significantly between the two methods.

Uploaded by

lenguyenngochan8827
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as DOCX, PDF, TXT or read online on Scribd
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Variable costing and absorption costing are two different methods of accounting for production costs.

They primarily differ in how fixed manufacturing costs are treated and assigned to products. Here's a
breakdown of the key differences:

1. Treatment of Fixed Manufacturing Costs:

 Variable Costing: Fixed manufacturing costs are treated as period costs and are expensed in the
period in which they are incurred. They are not assigned to individual units of product.

 Absorption Costing: Fixed manufacturing costs are treated as product costs and are absorbed
into the cost of the product. These costs are assigned to each unit of production and are
expensed as part of the cost of goods sold when the product is sold.

2. Cost per Unit:

 Variable Costing: The cost per unit includes only variable manufacturing costs (direct materials,
direct labor, and variable overhead). Fixed manufacturing costs are not included in the cost of
goods sold or inventory.

 Absorption Costing: The cost per unit includes both variable manufacturing costs and fixed
manufacturing costs. Therefore, the cost per unit under absorption costing is typically higher
because it includes a share of the fixed costs.

3. Income Statement Format:

 Variable Costing: The income statement separates costs into variable and fixed categories. It
typically uses a contribution margin format:

o Sales Revenue

o Less: Variable Costs

o Contribution Margin

o Less: Fixed Costs

o Net Income

 Absorption Costing: The income statement combines both fixed and variable costs as part of the
cost of goods sold, resulting in a simpler format:

o Sales Revenue

o Less: Cost of Goods Sold (including both variable and fixed manufacturing costs)

o Gross Profit

o Less: Operating Expenses

o Net Income

4. Impact on Profit:
 Variable Costing: Profit is more directly affected by sales volume because fixed costs are not
allocated to products. When sales increase, profit increases as fixed costs do not change.

 Absorption Costing: Profit can be influenced by production levels as well. If production exceeds
sales, some of the fixed costs are assigned to inventory, which can result in a higher reported
profit (even if sales don't increase).

5. Usefulness for Decision Making:

 Variable Costing: Useful for internal decision-making because it helps managers understand the
contribution margin and how changes in sales or production affect profitability.

 Absorption Costing: Required for external financial reporting (under GAAP or IFRS), as it adheres
to the matching principle of accounting, where all manufacturing costs are matched with
revenues in the period in which the product is sold.

6. Inventory Valuation:

 Variable Costing: Inventory is valued only on the basis of variable manufacturing costs. Fixed
manufacturing costs are excluded from inventory valuation.

 Absorption Costing: Inventory is valued based on both variable and fixed manufacturing costs.
Therefore, inventory under absorption costing tends to be valued higher than under variable
costing.

Summary Table:

Feature Variable Costing Absorption Costing

Treatment of Fixed
Period costs (expensed in the period) Product costs (allocated to units)
Costs

Only variable costs (direct materials, direct Variable + fixed manufacturing


Cost per Unit
labor, variable overhead) costs

Income Statement
Contribution margin format Traditional format (Gross Profit)
Format

Affected by both production and


Profit Fluctuations Affected by sales volume
sales volume

External financial reporting


Usefulness Internal decision making
(GAAP/IFRS)

Both variable and fixed costs


Inventory Valuation Only variable costs included
included

In summary, the main distinction lies in how fixed manufacturing costs are treated. Variable costing
focuses on the variable costs of production, while absorption costing includes both fixed and variable
costs as part of the cost of goods sold and inventory.

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