Absorption costing and variable costing are two distinct accounting methods used for valuing and reporting costs in business operations. Each method has its implications on financial reporting, decision making, and managerial strategies.
Historical Context
Absorption costing, also known as full costing, became widely used in the early 20th century as industrial operations grew in complexity. This method aimed to ensure that all costs, including fixed overheads, were allocated to production, thereby offering a comprehensive view of product profitability.
Variable costing, on the other hand, emerged as businesses sought more dynamic and flexible costing methods to support management decision-making processes. This method focuses on the costs that vary directly with the level of production, providing clearer insights into the marginal costs of production and operations.
Definitions
- Absorption Costing: An accounting method that includes all manufacturing costs - direct materials, direct labor, and both variable and fixed manufacturing overheads - in the cost of a product.
- Variable Costing: An accounting method that includes only variable manufacturing costs - direct materials, direct labor, and variable manufacturing overheads - in the cost of a product. Fixed manufacturing overheads are treated as period costs and expensed in the period they are incurred.
Key Differences
Cost Inclusions
- Absorption Costing: Includes all manufacturing costs (fixed and variable).
- Variable Costing: Includes only variable manufacturing costs.
Financial Statements Impact
- Absorption Costing: Fixed manufacturing overheads are included in inventory values and expensed as COGS when inventory is sold.
- Variable Costing: Fixed manufacturing overheads are expensed in the period incurred, affecting the operating income directly.
Decision Making
- Absorption Costing: May provide less relevant information for decision-making due to fixed overhead allocation.
- Variable Costing: More relevant for short-term decisions as it reflects the incremental costs of production.
Mathematical Formulas and Models
Absorption Costing
Variable Costing
Charts and Diagrams
flowchart TB
A[Absorption Costing] --> B[Includes Fixed Overheads]
A --> C[Variable Manufacturing Costs]
C --> D[Direct Materials]
C --> E[Direct Labor]
C --> F[Variable Overheads]
G[Variable Costing] --> H[Excludes Fixed Overheads]
G --> I[Variable Manufacturing Costs]
I --> J[Direct Materials]
I --> K[Direct Labor]
I --> L[Variable Overheads]
Importance and Applicability
Both costing methods have their unique importance and applicability:
- Absorption Costing: Required by GAAP for external reporting. Provides a complete view of product costs.
- Variable Costing: Useful for internal management purposes, particularly for decision-making related to pricing, production levels, and profitability analysis.
Examples and Considerations
Example: A company produces 1,000 units with the following costs:
- Direct Materials: $10/unit
- Direct Labor: $5/unit
- Variable Overhead: $3/unit
- Fixed Overhead: $20,000 total
Under Absorption Costing:
- Per Unit Cost: $10 + $5 + $3 + ($20,000/1,000) = $38/unit
Under Variable Costing:
- Per Unit Cost: $10 + $5 + $3 = $18/unit
Related Terms
- Cost of Goods Sold (COGS): The direct costs attributable to the production of the goods sold by a company.
- Period Costs: Costs that are expensed in the period in which they are incurred (e.g., fixed manufacturing overheads in variable costing).
- Contribution Margin: Sales revenue minus variable costs. Used in variable costing for decision-making.
Comparisons
- Profit Reporting: Absorption costing may show higher profits when inventory levels increase as some fixed overhead costs are included in ending inventory.
- Decision Utility: Variable costing offers better insights for short-term decisions due to the exclusion of fixed overheads from product costs.
Interesting Facts
- Absorption costing can sometimes lead to overproduction to spread fixed costs over more units, potentially leading to excess inventory.
- Variable costing aligns more closely with contribution margin analysis, aiding in understanding the impact of changes in sales volume on profitability.
Inspirational Stories
Mary Parker Follett, a pioneer in management theory, emphasized the importance of understanding both fixed and variable costs in managerial decision-making. Her work laid the groundwork for the development and application of variable costing in modern businesses.
Famous Quotes
- Peter Drucker: “What gets measured gets managed.”
- W. Edwards Deming: “In God we trust; all others must bring data.”
Proverbs and Clichés
- “Penny wise, pound foolish.” (Emphasizing the need to understand total costs rather than just variable costs)
- “You can’t manage what you don’t measure.”
Jargon and Slang
- Capex: Capital Expenditures.
- Opex: Operating Expenses.
- COGS: Cost of Goods Sold.
- Fixed Overheads: Costs that do not vary with production levels.
FAQs
Q: Why is absorption costing required by GAAP? A: Absorption costing is required by GAAP for external reporting because it provides a comprehensive view of production costs, ensuring that all manufacturing expenses are accounted for in product pricing.
Q: When is variable costing preferred? A: Variable costing is preferred for internal management purposes, particularly for making decisions related to pricing, production, and cost control.
Q: Can a company use both costing methods? A: Yes, a company can use absorption costing for external reporting and variable costing for internal decision-making.
References
- Horngren, C.T., Datar, S.M., & Rajan, M.V. (2015). Cost Accounting: A Managerial Emphasis. Pearson.
- Drury, C. (2013). Management and Cost Accounting. Cengage Learning.
Summary
Understanding the differences between absorption costing and variable costing is crucial for effective financial management and decision-making. Absorption costing provides a fuller picture for external reporting, while variable costing offers actionable insights for internal management, particularly in analyzing the impact of variable costs on profitability.
By grasping these costing methods, businesses can better align their financial strategies with their operational realities, driving informed decisions and sustainable growth.
