This paper compares absorption costing and variable costing as two fundamental methods for determining product costs. It explains how absorption costing treats all manufacturing costs — fixed and variable — as product costs, while variable costing classifies fixed manufacturing overhead as a period cost. Using a numerical example, the paper illustrates the difference in unit product cost calculations under each method and the resulting impact on gross profit. The discussion also addresses the treatment of selling and administrative expenses, the internal and external uses of each method, and why Generally Accepted Accounting Principles (GAAP) require absorption costing for external financial reporting.
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Absorption costing is a costing method that treats all costs of production as product costs, regardless of whether those costs are variable or fixed. Under the absorption costing method, the cost of a unit of product comprises direct materials, direct labor, and both variable and fixed overhead. This method allocates a portion of fixed manufacturing cost to each unit of a product along with the variable manufacturing cost. Because it includes all costs of production as product costs, absorption costing is often referred to as the full costing method.
Under variable costing, only costs of production that vary with output are treated as product costs. Product costs under this method therefore include direct materials, direct labor, and the variable portion of manufacturing overhead. Fixed manufacturing costs are not treated as product costs; instead, they are classified as period costs and, like selling and administrative expenses, are charged off in their entirety against revenue in the period incurred. As a result, the cost of a unit of product in inventory or cost of goods sold under variable costing contains no fixed overhead. Variable costing is sometimes referred to as direct costing or marginal costing.
Regardless of whether a company uses variable or absorption costing, selling and administrative expenses are never treated as product costs. Both variable and fixed selling and administrative expenses are treated as period costs under either method and are deducted from revenues in the period in which they are incurred.
Variable and absorption costing are methods used by successful companies around the world. They cannot be substituted for one another because each has unique benefits and limitations. Information derived from variable costing is typically used by internal management when making critical decisions, while absorption costing is used by both internal management and external parties such as creditors, government agencies, and auditors.
There are notable differences between variable and absorption costing when computing unit product costs. Consider a company that produces 6,000 units with the following variable costs per unit: $2 in direct materials, $4 in direct labor, $1 in variable manufacturing overhead, and $3 in variable selling and administrative expenses. Its fixed costs per year are $30,000 in fixed manufacturing overhead and $10,000 in fixed selling and administrative expenses.
Under absorption costing, the unit product cost is $12. Under variable costing, the unit product cost totals $7. In variable costing, only direct materials, direct labor, and variable manufacturing overhead are summed as product costs. Absorption costing adds fixed manufacturing overhead of $5 per unit (i.e., $30,000 ÷ 6,000 units) to those same costs, yielding the higher $12 unit cost. If all 6,000 units are sold, the company would realize a gross profit of $42,000 using variable costing and $72,000 using absorption costing.
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