The key difference between absorption and variable costing is (fixed, variable) overhead.

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.

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Absorption Costing

Generally accepted accounting principles require use of absorption costing (also known as “full costing”) for external reporting. Under absorption costing, normal manufacturing costs are considered product costs and included in inventory.

The rationale for absorption costing is that it causes a product to be measured and reported at its complete cost. Because costs like fixed manufacturing overhead are difficult to identify with a particular unit of output does not mean that they were not a cost of that output. As a result, such costs are allocated to products. However valid the claims are in support of absorption costing, the method does suffer from some deficiencies as it relates to enabling sound management decisions. Absorption costing information may not always provide the best signals about how to price a product, reach conclusions about discontinuing a product, and so forth.

Variable Costing

This last point can be made clear with a very simple illustration. Assume that a company produces 10,000 units of a product, and per unit costs are $2 for direct material, $3 for direct labor, and $4 for variable factory overhead. In addition, fixed factory overhead amounts to $10,000. The product cost under absorption costing is $10 per unit, consisting of the variable cost components ($2 + $3 + $4 = $9) and $1 of allocated fixed factory overhead ($10,000/10,000 units). Under variable costing, the product cost is limited to the variable production costs of $9. Now consider a “management decision.” Assume the company is approached to sell one additional unit at $9.50. This sale will not result in any added SG&A cost or otherwise impact sales of other units.

Variable Costing In Action

Double-Edged Sword

A typical illustration of decision making based on variable costing data looks simple enough. But, such decisions are actually very tricky. Considerable business savvy is necessary, and there are several traps that must be avoided. First, a business must ultimately recover the fixed factory overhead and all other business costs; the total units sold must provide enough margin to accomplish this purpose. It would be easy to use up full manufacturing capacity, one sale at a time, and not build in enough margin to take care of all the other costs. If every transaction were priced to cover only variable cost, the entity would quickly go broke. Second, if a company offers special deals on a selective basis, regular customers may become alienated or hold out for lower prices. The key point here is that variable costing information is useful, but it should not be the sole basis for decision making.

Avoiding A Downward Spiral

Variable costing data are quite useful in avoiding incorrect decisions about product discontinuation. Many businesses offer multiple products. Some will usually be more successful than others, and a logical business decision may be to focus on the best-performing units, while discontinuing others. Assume that a company offers products A, B, and C. Each is being produced in equal proportion, and the company is fully able to meet customer demand from existing capacity (i.e., producing more will not increase sales). The company is not incurring any variable costs relating to selling, general, and administration efforts.

From the absorption costing data in the dark shaded area, it appears that Product A is yielding a negative gross profit. Logically, a manager may target that product for discontinuation. However, if that decision is reached, Products B and C will each have to absorb more fixed factory overhead. The revised cost data (in the light shaded area) show that eliminating Product A will actually reduce overall profitability!

The decline in overall profits from discontinuing the “loser” occurs because the “loser” was absorbing some fixed cost of production. The $15 selling price for Product A at least covered its variable cost ($6 + $5 + $3 = $14) and contributed toward coverage of the business’s unavoidable fixed cost burden. The lesson here is that a company must be very careful in eliminating “unprofitable” products. This decision can often result in a series of successive shifts in overhead to other remaining products. This, in turn, can cause other products to also appear unsuccessful.

A downward spiral of product discontinuation decisions can ultimately destroy a business that was otherwise successful. This illustration underscores why a good manager will not rely exclusively on absorption costing data. Variable costing techniques that help identify product contribution margins (as more fully described in the following paragraphs) are essential to guiding the decision process.

Variable costing is not a panacea, and guiding a business is not easy. Decision making is not as simple as applying a single mathematical algorithm to a single set of accounting data. A good manager must consider business problems from multiple perspectives. In the context of measuring inventory and income, a manager will want to understand both absorption costing and variable costing techniques. This information must be interlaced with knowledge of markets, customer behavior, and the like. The resulting conclusions can set in motion plans of action that bear directly on the overall fate of the organization.

Income Statement

Much of the preceding discussion focused on per-unit cost assessments. In addition, the examples assumed that selling, general, and administrative costs were not impacted by specific actions. It is now time to consider aggregated financial data and take into account shifting amounts of SG&A. The following income statements present information about Nepal Company. On the left is the income statement prepared using the absorption costing method, and on the right is the same information using variable costing. For now, assume that Nepal sells all that it produces, resulting in no beginning or ending inventory.

With absorption costing, gross profit is derived by subtracting cost of goods sold from sales. Cost of goods sold includes direct materials, direct labor, and variable and allocated fixed manufacturing overhead. From gross profit, variable and fixed selling, general, and administrative costs are subtracted to arrive at net income. This approach should look familiar. It is the presentation that is typical of financial statements generated for general use by shareholders and other persons external to the daily operations of a business.

With variable costing, all variable costs are subtracted from sales to arrive at the contribution margin. Nepal’s presentation divides variable costs into two categories. The variable product costs include all variable manufacturing costs (direct materials, direct labor, and variable manufacturing overhead). These costs are subtracted from sales to produce the variable manufacturing margin. Some of Nepal’s SG&A costs also vary with sales. As a result, these amounts must also be subtracted to arrive at the true contribution margin. Management must take into account all variable costs (whether related to manufacturing or SG&A) in making critical decisions. For instance, Nepal may pay sales commissions that are based on sales; to exclude those from consideration in evaluating the “margin” that is to be generated from a particular transaction or event would be quite incorrect. From the contribution margin are subtracted both fixed factory overhead and fixed SG&A costs.

Because Nepal does not carry inventory, the income is the same under absorption and variable costing. The difference is only in the manner of presentation. Carefully study the arrows that show how amounts appearing in the absorption costing approach would be repositioned in the variable costing income statement. Since the bottom line is the same under each approach, this may seem like much to do about nothing. But, remember that “gross profit” is not the same thing as “contribution margin,” and decision logic is often driven by consideration of contribution effects. Further, when inventory levels fluctuate, the periodic income will differ between the two methods.

Impact Of Inventory

The following income statements are identical to those previously illustrated, except sales and variable expenses are reduced by 10%. Assume that the units relating to the “10% reduction” were nevertheless manufactured. What is the effect of this inventory build-up? Income is higher under absorption costing by $15,000. This is consistent with a general rule of thumb: Increases in inventory cause income to be higher under absorption costing than under variable costing, and vice versa.

To further examine the reason income is higher, remember that $450,000 was attributed to total production under absorption costing. Of this amount, 10% ($45,000) is now diverted into inventory. Under variable costing, total product costs were $300,000 and 10% ($30,000) of that amount would be assigned to inventory. As a result, $15,000 more is assigned to inventory under absorption costing. This logically coincides with the degree to which income is higher! Another way to view the impact of the inventory build-up is to examine the following “cups.” The top set of cups initially contains the costs incurred in the manufacturing process. With absorption costing, those cups must be emptied into either cost of goods sold or ending inventory.

Compare the drawing above to the variable costing illustration that follows. The ending inventory cup contains less with variable costing because there is no fixed factory overhead in ending inventory!

Recognize that a reduction in inventory during a period will cause the opposite effect from that shown. Specifically, a portion of the contents of the beginning inventory cup would be transferred to expense commensurate with the decrease in inventory. Since the inventory cup contains less under variable costing, expect expenses to be lower and income to be higher.