Variable vs. Absorption Costing

Variable vs. Absorption Costing

Variable costing, also known as direct costing, differs from absorption (full) costing.

Absorption Costing

Absorption costing includes all manufacturing overhead costs (variable and fixed) in product costs. This is required for inventory valuation under accounting standards.

• Includes: Direct labor, direct material, variable overhead, and fixed overhead.

Variable Costing

Variable costing only includes variable manufacturing overhead costs in product costs, along with direct materials and direct labor.

• Excludes: Fixed overhead; treats it as a period cost.

Key Differences

• Fixed Manufacturing Overhead: The critical difference lies in the treatment of fixed manufacturing overhead. Absorption costing includes it in product costs, while variable costing expenses it separately.

Impact on Profit

The choice of costing method impacts the value of:

• Cost of goods sold.
• Inventory (finished goods).
• Ultimately, reported profit.

Variable costing is the basis for CVP analysis.

Example

Consider a unit selling for $40$ with direct costs of $12$, fixed manufacturing overhead of $210,000$ (30,000 units), and fixed selling/admin expenses of $250,000$.

• Absorption Costing: Unit product cost is $19$ ($12$ direct + $7$ fixed overhead per unit).
• Variable Costing: Unit product cost is $12$ (only direct costs).

Profit and Loss Comparison

Under absorption costing, ending inventory is valued higher, potentially leading to a higher profit compared to variable costing if production exceeds sales.

Reconciliation

The difference in profit between the two methods is due to the fixed overhead included in ending inventory under absorption costing but expensed entirely under variable costing.

• Calculate the change in inventory units multiplied by the predetermined fixed overhead rate per unit to reconcile the profit difference.

Long-Run Perspective

In the long run, the total profit under both costing methods will be the same, especially with Just-In-Time (JIT) inventory management.

• Just-In-Time: JIT aims for zero inventory, eliminating differences between absorption and variable costing.

Advantages and Disadvantages

• Variable Costing Criticisms: it undervalues finished goods inventory and may distort pricing decisions.

• Absorption Costing Advantages: Complies with accounting standards and taxation case law for asset valuation.