What is the Difference Between Absorption Costing and Variable Costing?
🆚 Go to Comparative Table 🆚Absorption costing and variable costing are two methods used to value companies' work in progress and for accounting purposes. The main difference between the two lies in how they treat fixed overhead costs:
Absorption Costing:
- Includes all direct costs, fixed overhead, and variable manufacturing overhead in the cost of a product.
- Allocates fixed overhead costs to a product whether or not it was sold in the period.
- More cost is included in the ending inventory, which is carried over into the next period as an asset on the balance sheet.
- Lower expenses on the income statement compared to variable costing.
Variable Costing:
- Only includes variable costs directly incurred in production.
- Fixed overhead costs are expensed in the period in which they occur.
- Determines a lump-sum for fixed overhead costs.
In summary, absorption costing accounts for all direct costs, fixed overhead, and variable manufacturing overhead in the cost of a product, while variable costing only includes the variable costs directly incurred in production. Absorption costing is typically used for external reporting purposes, such as calculating the cost of goods sold for financial statements, while variable costing is more suitable for internal decision-making processes.
Comparative Table: Absorption Costing vs Variable Costing
Here is a table comparing the differences between absorption costing and variable costing:
| Feature | Absorption Costing | Variable Costing |
|---|---|---|
| Definition | Includes all costs related to production, such as direct materials, direct labor, variable manufacturing overhead, and fixed manufacturing overhead | Includes only variable costs directly incurred in production, such as direct materials, direct labor, and variable manufacturing overhead |
| Treatment of Fixed Costs | Fixed manufacturing overhead is reported as a product cost, included in inventory on the balance sheet until sold | Fixed manufacturing overhead is reported as a period cost, expensed as incurred |
| Per Unit Cost Calculation | Direct materials + Direct labor + Variable manufacturing overhead + Fixed manufacturing overhead | Direct materials + Direct labor + Variable manufacturing overhead |
| Profit Calculation | Profit is difficult to predict as it depends on various factors, including sales | Profit is easier to predict as it is a function of sales |
| Reporting Requirements | Generally accepted accounting principles require use of absorption costing | Supplemental data based on variable costing can be generated to complement absorption costing data |
Absorption costing provides a more accurate picture of the true costs of production, while variable costing is typically more straightforward to implement. Companies often use both methods to get the most accurate possible picture of their costs.
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