Absorption Costing Is a Costing Method Which

Absorption costing is a costing method which treats all costs of production as product costs without considering whether these costs are variable or fixed (AccountingforManagement, 2013). Under the absorption costing method the cost of a unit product comprises direct materials, direct labor, and both variable and fixed overhead. This costing method allocates a portion of fixed manufacturing cost to each unit of a product along with the variable manufacturing cost (AccountingforManagement, 2013). It includes all costs of production as product cost. That is why it is often called a full costing method.

Under variable costing costs of production varying with output are treated as product costs. Product costs under this costing method therefore include costs of direct material, direct labor, and variable portion of manufacturing overhead. Fixed manufacturing cost does not therefore fall under product costs (AccountingforManagement, 2013). It is nevertheless, treated as period cost and just like selling and administrative expenses, it is charged off in its entirety against revenue. Consequently, the cost of a unit of a product in inventory or cost of goods sold under this costing method does not contain any fixed overhead cost (AccountingforManagement, 2013). Variable costing is at times referred to as direct costing or marginal costing.

Whether a company uses variable or absorption costing methods selling and administrative expenses are never treated as product costs (AccountingforManagement, 2013). Variable and fixed selling and administrative expenses are treated as period costs and are deducted from revenues.

Variable and absorption are costing methods used by successful companies across the globe. These costing methods cannot be substituted for one another because each has its unique benefits and limitations. Information gleaned from variable costing method is normally used by the internal management in making critical decisions (AccountingforManagement, 2013). On the other side, absorption costing method is used both by internal management and external parties like the creditors, government agencies, and auditors. There are glaring differences between variable and absorption costing methods when it comes to computation of unit product cost. This can be illustrated using an example below.

A company that produces 6,000 units has variable costs per unit thus: $2 direct materials; $4 direct labor: $1 variable manufacturing overhead; and $3 variable selling and administrative expenses. Its fixed costs per year are $30, 0000 in fixed manufacturing overhead and $10, 000 in fixed selling and administrative expenses. The unit product cost computed using absorption costing method will be $12 while the unit product cost calculated using the variable costing method will total $7. In variable costing method the costs of direct materials, direct labor, and variable manufacturing will be summed up. However, the absorption costing method will add fixed manufacturing overhead of $5 to these costs hence the $12 unit cost price. Considering that the company produces 6, 000 units, the company stands to make a gross profit of $42,000 and $72, 000 using the variable and absorption costing method respectively if all the units are sold.