Manufacturing companies often struggle with choosing the right costing method for their operations.
This article will clearly explain the key differences between variable and absorption costing to help you determine which approach is better suited for your business.
We will define both methods, analyze their effects on net income and inventory valuation, highlight the advantages of each, and provide examples and sample calculations to illustrate the concepts. By the end, you'll have the knowledge to select the most appropriate costing technique based on your company's specific needs and reporting objectives.
Introduction to Variable and Absorption Costing
Variable costing, also known as direct costing, only includes variable production costs in determining the cost of a product. Fixed overhead costs are treated as period costs and expensed in the period incurred rather than allocated to units produced. In contrast, absorption costing, also known as full costing, allocates a share of both variable and fixed manufacturing costs to each unit produced.
Defining Variable Costing
Variable costing is an accounting method that includes only variable production costs—direct materials, direct labor, and variable manufacturing overhead—as product costs. Fixed overhead costs are considered period costs and are expensed in the period incurred, rather than allocated to units produced.
Some key characteristics of variable costing:
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Only variable costs are included in product costs
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Fixed costs are treated as period expenses
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Contribution margin analysis is easier
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Income fluctuates with production volumes
Variable costing provides useful information for management decisions related to pricing, product mix optimization, and incremental analysis.
Defining Absorption Costing
Absorption costing allocates a share of all manufacturing costs, including fixed overhead costs, to units produced. These allocated fixed and variable costs are then treated as product costs rather than period costs.
Some key characteristics of absorption costing:
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Both fixed and variable costs are included in product costs
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No fixed costs are treated as period expenses
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Income is less volatile from period to period
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Aligns with GAAP external reporting standards
Absorption costing is required for external financial reporting under [gaap](/blog/<a href=)-generally-accepted-accounting-principles/">generally accepted accounting principles (GAAP). It provides a fuller allocation of costs for inventory valuation and income determination.
Key Differences and Income Effects Under Both Methods
The key difference between variable and absorption costing lies in the treatment of fixed manufacturing overhead costs. Under variable costing, these costs are expensed in the period incurred. Under absorption costing, they are allocated to units produced as product costs.
This drives several further differences:
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Product costs and cost of goods sold are higher under absorption costing
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Income is affected by production volumes under variable costing but not absorption costing
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Inventory valuations differ between the two methods
Careful analysis of cost behavior is needed when comparing income figures between variable and absorption costing.
What is the difference between variable and absorption costing?
Variable and absorption costing are two different methods of allocating costs in managerial accounting. The key differences are:
Variable Costing
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Treats fixed manufacturing overhead costs as period costs, which are fully expensed in the period incurred
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Cost of goods sold only includes direct materials, direct labor, and variable manufacturing overhead costs
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Contribution margin and net income tend to be higher compared to absorption costing
Absorption Costing
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Allocates fixed manufacturing overhead costs to units produced, based on the normal capacity for the period
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Cost of goods sold includes all manufacturing costs - both fixed and variable
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Net income tends to be lower compared to variable costing
The choice of costing method can impact the valuation of inventory and the measurement of net income. Variable costing provides a better view of marginal profitability, while absorption costing adheres more closely to GAAP and matches all production costs against revenue.
Most companies will use absorption costing for external financial reporting, in accordance with GAAP standards. However, variable costing may be useful for internal decision-making and analysis of profitability. Understanding the differences between these methods is important for managers.
What is the difference between variable marginal and absorption costing?
Variable costing and absorption costing are two different methods of allocating costs for product costing and income statement reporting. The key differences are:
Variable Costing
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Only includes variable manufacturing costs in product costs
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Fixed manufacturing costs are treated as period costs and directly expensed in the period incurred
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Generally yields higher net income during periods of rising production volumes
Absorption Costing
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Includes both variable and fixed manufacturing costs in product costs
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Uses predetermined overhead rates to allocate fixed manufacturing costs to units produced
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Generally yields lower net income than variable costing in periods of rising production volumes
The choice of costing method can significantly impact the valuation of inventory and the amount of net income reported. Companies should understand these differences and select the costing method that best suits their business and industry accounting standards.
In summary, variable costing is simpler and excludes fixed costs from inventory valuation, while absorption costing is more complex but is required under GAAP as it better matches costs to revenue. The costing method impacts the timing of expense recognition and net income reporting.
What is the only difference between absorption costing and variable costing is the treatment of fixed manufacturing overhead costs?
The key difference between absorption costing and variable costing lies in how fixed manufacturing overhead costs are handled.
Absorption costing treats fixed manufacturing overhead as a product cost. This means that a portion of fixed overhead is allocated to each unit produced. Under absorption costing, fixed overhead is considered part of the cost of goods manufactured and becomes an asset until the inventory is sold.
In contrast, variable costing treats fixed manufacturing overhead as a period cost. This means that fixed overhead is expensed in the period in which it is incurred, rather than allocating it to inventory.
So in summary:
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Absorption costing allocates fixed overhead to inventory, while variable costing expenses fixed overhead in the period incurred.
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Absorption costing includes fixed overhead as part of product costs, while variable costing excludes fixed overhead from product costs.
The treatment of fixed manufacturing overhead is the only difference between the two costing methods. All other product costs like direct materials and direct labor are treated the same.
This difference in fixed overhead treatment leads to differences in cost of goods sold and net income between absorption and variable costing. But the core principles and calculations are identical outside of fixed overhead allocation.
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Why is absorption costing more widely used then variable costing?
Absorption costing is more widely used than variable costing for a few key reasons:
It aligns with GAAP principles
Absorption costing is considered the standard approach under generally accepted accounting principles (GAAP). By allocating fixed manufacturing costs to inventory, absorption costing better matches expenses to revenues. This leads to less volatility in net income from period to period.
It provides a more comprehensive cost perspective
Since absorption costing allocates all manufacturing costs to products, it provides a more complete view of product costs. This helps inform better pricing decisions. With variable costing, fixed costs are excluded from inventory valuation which only reflects marginal costs.
It avoids issues with tax reporting
If a company uses variable costing for internal reporting, they would still need to prepare external financial statements using absorption costing to comply with tax regulations. Adopting absorption costing eliminates this redundant work.
Overall, absorption costing principles better align with financial accounting standards and provide a more accurate, stable view of manufacturing costs. This comes at the expense of income statement volatility. Companies have to weigh these factors based on their specific accounting needs and industry dynamics when choosing between the two methods.
Understanding the Variable Costing Formula
Variable costing is a managerial accounting method that includes only variable production costs—direct materials, direct labor, and variable manufacturing overhead—in unit product costs. Fixed manufacturing overhead costs are treated as period costs and are deducted in full as an expense in the period incurred.
The key components of the variable costing formula are:
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Sales revenue
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Variable product costs
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Direct materials
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Direct labor
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Variable manufacturing overhead
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Period costs
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Fixed manufacturing overhead
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Operating expenses (selling, general and administrative)
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The formula to calculate net income under variable costing is:
Net Income = Sales - Variable Product Costs - Period Costs
Exploring the Variable Costing Formula
Under variable costing, product costs on the income statement include only variable manufacturing costs. Fixed factory overhead costs are treated as period costs. Here is an example income statement under the variable costing method:
Sales
Variable product costs:
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Direct materials
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Direct labor
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Variable manufacturing overhead Contribution margin Fixed costs:
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Fixed manufacturing overhead
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Operating expenses Net income
Contribution margin under variable costing is defined as sales revenue less variable product costs. This is an important metric as it represents the residual amount that is available to cover fixed costs and provide profit after the variable costs of production have been covered.
The key advantage of variable costing is that it provides a clearer picture of how changes in sales volume affect net income.
Variable Costing vs Absorption Costing Examples
Under absorption costing, all manufacturing costs—including fixed factory overhead—are treated as product costs. Here is an example income statement under absorption costing:
Sales Cost of goods sold:
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Direct materials
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Direct labor
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Variable manufacturing overhead
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Fixed manufacturing overhead Gross margin Operating expenses
Net income
Comparing the two methods:
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Under variable costing, fixed factory overhead is treated as a period cost and deducted in full from contribution margin to determine net income
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Under absorption costing, fixed factory overhead is allocated to units produced and included in inventory costs that flow through cost of goods sold
This means net income will always be higher under variable costing compared to absorption costing when production exceeds sales. The following example for Company X illustrates this:
| Financial Metric | Variable Costing | Absorption Costing |
|---|---|---|
| Sales | $100,000 | $100,000 |
| Variable product costs | $60,000 | $60,000 |
| Fixed factory overhead | $20,000 | $15,000 |
| Net income | $20,000 | $25,000 |
In this example, fixed overhead is lower under absorption costing due to $5,000 being stuck in inventory at the end of the period. This results in lower cost of goods sold and higher net income under absorption costing.
The income effects between the two methods reverse when units sold exceeds units produced. In this case, absorption costing will have higher net income.
Delving into Absorption Costing Calculations
Absorption costing is a costing method that allocates both variable costs and fixed manufacturing overhead costs to each unit produced. The key difference from variable costing is that fixed manufacturing overhead costs are treated as product costs under absorption costing.
Breaking Down the Absorption Costing Formula
The formula to calculate net income under absorption costing is:
Net Income = Sales - Total Product Costs (Variable Costs + Allocated Fixed Overhead) - Operating Expenses
Where:
- Total Product Costs = Direct Materials + Direct Labor + Variable Manufacturing Overhead + Fixed Manufacturing Overhead Allocated to Units Produced
To allocate fixed overhead costs, a predetermined overhead rate is calculated:
Predetermined Overhead Rate = Estimated Total Fixed Overhead Costs / Estimated Level of Activity (e.g. machine hours)
This rate is then used to assign a portion of the fixed overhead costs to each unit produced.
Compared to variable costing, absorption costing results in higher total product costs and lower net income in periods with lower production volumes. This occurs because fixed overhead costs are allocated across fewer units produced.
Absorption Costing Income Statement Illustration
Below is an example income statement prepared under absorption costing:
Sales $100,000
Variable Costs $60,000
Fixed Overhead Allocated $20,000
Total Product Costs $80,000
Gross Margin $20,000
Operating Expenses $10,000
Net Income $10,000
In this example, if 5,000 units were produced and total fixed overhead costs were $100,000, the predetermined overhead rate would be $20 per unit ($100,000/5,000 units). This $20 per unit fixed cost would be allocated as a product cost for each unit sold, along with the $60 per unit variable costs.
The allocation of fixed overhead to units produced means net income is lower than under variable costing, which treats fixed overhead solely as a period cost. However, absorption costing adheres to GAAP and provides a fuller valuation of inventory.
Comparing Absorption with Variable Costing
Absorption and variable costing are two common methodologies used to allocate manufacturing costs. The key differences between them relate to how fixed overhead costs are handled.
Income Statement Effects and Net Income Variations
Under variable costing, fixed overhead costs are treated as period expenses and are fully deducted in the period incurred. In contrast, absorption costing allocates a portion of fixed overhead to units produced. As a result:
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When production volumes increase, more fixed costs are deferred to inventory under absorption costing. This causes net income to be higher compared to variable costing.
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Conversely, when production declines, net income tends to be lower under absorption costing since less fixed overhead gets allocated to inventory.
In summary, net income is generally less volatile under variable costing.
Inventory Valuation Differences and Impact on Financials
Since more costs are capitalized to inventory under absorption costing, inventory balances on the balance sheet tend to be higher compared to variable costing.
Higher inventory values lead to lower cost of goods sold and higher gross margins as a percentage of revenue. As such, absorption costing results can make operational performance seem better.
Advantages of Absorption Costing
Absorption costing is considered the standard approach under generally accepted accounting principles (GAAP). Key advantages include:
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Inventory valuations better reflect all associated manufacturing costs
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Better matches expenses to revenue
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Provides more conservative profits and asset values
As such, absorption costing ensures proper inventory accounting and adheres to external reporting standards.
Absorption and Variable Costing Problems and Solutions
When choosing a costing method, key considerations include:
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External reporting requirements - Absorption costing may be required
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Inventory management - Absorption provides better cost control
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Internal decision making - Variable reflects marginal contributions
Potential solutions include:
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Use absorption costing for external reporting, variable for internal
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Develop inventory controls under variable costing
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Analyze both income statements for decisions
In summary, both methods have merits depending on business context and intended use. Using both aligned to their strengths can prove an effective solution.
Conclusion and Key Takeaways
In summary, variable and absorption costing differ primarily in their treatment of fixed manufacturing costs. While variable costing provides better data for decisions, absorption costing aligns with GAAP. Businesses must weigh the pros and cons of each to determine the optimal approach.
Recap of Variable Costing Advantages
Variable costing has several key advantages:
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Provides more accurate product cost data to support pricing decisions
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Fixed manufacturing costs are not allocated to inventory, so income statements reflect only costs that change with production volumes
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Helps businesses understand the incremental impact of manufacturing decisions
Recap of Absorption Costing Advantages
Absorption costing also has some notable benefits:
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Complies with generally accepted accounting principles (GAAP)
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Matches all manufacturing costs to revenue
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Values inventory and cost of goods sold more conservatively
Deciding Between Variable and Absorption Costing
Ultimately, companies should analyze their specific business and information needs and decide whether variable costing or absorption costing better aligns with their operational goals and objectives. Key factors to consider include GAAP compliance needs, how cost data is used for decision-making, and desired inventory valuation methods.
