Absorption vs. Variable Costing: A Detailed Review
Introduction to Costing Methods
Simplifying Assumptions: We assume variable manufacturing cost per unit and total fixed manufacturing overhead (MOH) per period remain constant.
Importance of Preamble: It is crucial to understand normal costing, the value of product costs, their use for cost of goods sold (COGS) and inventory, and the different income statement formats.
Absorption Costing Explained
Definition: This is the standard costing method that companies must use for external reporting under US GAAP (Generally Accepted Accounting Principles).
Product Costs: Under absorption costing, all costs associated with manufacturing a product are considered product costs. These include:
Direct Materials (DM)
Direct Labor (DL)
All Overhead: Both Variable Manufacturing Overhead (Variable MOH) and Fixed Manufacturing Overhead (Fixed MOH).
Period Costs: These are costs not directly tied to production and are expensed in the period they are incurred. They include:
Variable Selling and Administrative (S&A) Expenses
Fixed Selling and Administrative (S&A) Expenses
Variable Costing Explained
Definition: This is an alternative costing method not legal for external reporting under US GAAP but is highly beneficial for internal decision-making and analysis.
Key Difference: The one and only difference between absorption and variable costing lies in how Fixed Manufacturing Overhead (Fixed MOH) is treated.
In absorption costing, Fixed MOH is a product cost.
In variable costing, Fixed MOH is a period cost.
Product Costs: Only variable manufacturing costs are included in product costs:
Direct Materials (DM) (which are variable)
Direct Labor (DL) (which are variable)
Variable Manufacturing Overhead (Variable MOH)
Period Costs: All non-manufacturing costs and Fixed MOH are treated as period costs:
Fixed Manufacturing Overhead (Fixed MOH)
Variable Selling and Administrative (S&A) Expenses
Fixed Selling and Administrative (S&A) Expenses
Implications for CVP Analysis
Advantage of Variable Costing: Variable costing is superior for Cost-Volume-Profit (CVP) analysis (e.g., calculating break-even points, evaluating profitability impacts of sales/price/advertising changes).
Reason: By categorizing costs strictly as variable or fixed, the income statement format under variable costing directly facilitates CVP analysis. Absorption costing tends to
Introduction to Costing Methods
Simplifying Assumptions: We assume variable manufacturing cost per unit and total fixed manufacturing overhead (MOH) per period remain constant.
Importance of Preamble: It is crucial to understand normal costing, the value of product costs, their use for cost of goods sold (COGS) and inventory, and the different income statement formats.
Absorption Costing Explained
Definition: This is the standard costing method that companies must use for external reporting under US GAAP (Generally Accepted Accounting Principles).
Product Costs: Under absorption costing, all costs associated with manufacturing a product are considered product costs. These include:
Direct Materials (DM)
Direct Labor (DL)
All Overhead: Both Variable Manufacturing Overhead (Variable MOH) and Fixed Manufacturing Overhead (Fixed MOH).
Period Costs: These are costs not directly tied to production and are expensed in the period they are incurred. They include:
Variable Selling and Administrative (S&A) Expenses
Fixed Selling and Administrative (S&A) Expenses
Variable Costing Explained
Definition: This is an alternative costing method not legal for external reporting under US GAAP but is highly beneficial for internal decision-making and analysis.
Key Difference: The one and only difference between absorption and variable costing lies in how Fixed Manufacturing Overhead (Fixed MOH) is treated.
In absorption costing, Fixed MOH is a product cost.
In variable costing, Fixed MOH is a period cost.
Product Costs: Only variable manufacturing costs are included in product costs:
Direct Materials (DM) (which are variable)
Direct Labor (DL) (which are variable)
Variable Manufacturing Overhead (Variable MOH)
Period Costs: All non-manufacturing costs and Fixed MOH are treated as period costs:
Fixed Manufacturing Overhead (Fixed MOH)
Variable Selling and Administrative (S&A) Expenses
Fixed Selling and Administrative (S&A) Expenses
Implications for CVP Analysis
Advantage of Variable Costing: Variable costing is superior for Cost-Volume-Profit (CVP) analysis (e.g., calculating break-even points, evaluating profitability impacts of sales/price/advertising changes).
Reason: By categorizing costs strictly as variable or fixed, the income statement format under variable costing directly facilitates CVP analysis. Absorption costing tends to