Absorption Costing VS Variable Costing

Other hands, variable costing only includes variable production costs in COGS and excludes fixed overhead costs. This means that fixed overhead costs are treated as period expenses rather than product costs. The major difference between absorption costing and variable costing is how they treat fixed manufacturing operations expenses.

Definition of Absorption costing

Absorption costing is a managerial accounting method used to capture all costs associated with manufacturing a product. It is also known as full absorption costing since it assigns all manufacturing costs, including direct materials, direct labor, and both variable and fixed overhead costs, to the units of goods produced.

Advantages of Absorption Costing

GAAP-Compliant

The Generally Accepted Accounting Principles (GAAP) require businesses to use absorption costing to prepare their financial statements. So using this method, you can provide that the financial statements are compliant with GAAP. It is essential for businesses that are publicly traded.

Includes All Costs of Production

Absorption costing takes into account all costs of production, including direct and indirect costs. This includes direct materials, direct labour, variable overhead, and fixed overhead. Because all expenses are included in the cost of goods sold, this method provides a more accurate depiction of the true cost of a product.

Useful in Determining an Appropriate Selling Price for Products

By including all costs of production, absorption costing allows businesses to determine the actual cost of producing a product. So this, in return, it allows businesses to set a selling price. That covers all costs and provides a reasonable profit margin.

Provides a More Realistic Cost of a Product

Absorption costing provides a more realistic cost of a product than variable costing, which only includes direct costs. By including both direct and indirect costs, businesses can see the true cost of production, including the fixed overhead costs.

Suitable for Preparing Accounts

Absorption costing is widely use in preparing accounts as it is required by GAAP. It provides a comprehensive view of all costs associated with producing a product, which is essential for preparing financial statements.

Disadvantages of Absorption Costing

Not Useful for Product Decision-Making

Absorption costing is not useful for product decision-making, as it includes both fixed and variable costs. So basically this makes it difficult to identify the costs that are directly related to the production of a specific product. 

For example, if a business is considering introducing a new product, absorption costing may not provide an accurate picture of the costs associated with producing that product.

Can Skew a Company’s Profit Level

Absorption costing can skew a company’s profit level as it includes fixed overhead costs that do not vary with the level of production. This means that if a company produces more products, the cost per unit falls, making the company appear more profitable than it is.

Not Accounting for Changes in Production Levels

Absorption costing does not account for changes in production levels. This means that if a company’s production increases or decreases significantly, the cost per unit may not correctly reflect the true cost of manufacturing.

Potential for Misleading Financial Statements

Absorption costing has the potential to mislead financial statements as it includes fixed overhead costs that do not vary with production. So this can make a business appear more profitable than it actually is, which can be misleading to investors.

Absorption Costing vs Variable Costing 

• Absorption costing considers both direct and indirect costs associated with manufacturing a product, 
• Absorption costing allocates fixed overhead costs to all units produced for an accounting period, 
• Absorption costing is required under GAAP for external reporting, 
• Absorption costing can provide a more comprehensive COGS, which includes both variable and fixed costs, 
• Absorption costing increases COGS and decreases gross profit per unit produced, which can result in a higher breakeven price on production per unit, 
• Absorption costing may result in a lower gross profit margin, 
• Absorption costing may be more efficient to use for companies with COGS, while variable costing can be used for internal accounting purposes and for valuing work in progress and finished inventory.

Advantages of Variable Costing

Provides a More Accurate View of Profitability

One of the most significant benefits of variable costing is that it delivers a more realistic picture of profitability. einsteineruploading up to get together with.

Helps Businesses in Making Better Choices

Variable costing not only provides a more realistic depiction of profitability, but it also assists businesses in making better decisions. Businesses can optimize their production processes by understanding the relationship between output levels and costs. To reduce costs while increasing earnings.

Help in CVP Analysis

CVP analysis is a critical tool for firms wanting to understand how changes in production levels affect profitability. Variable costing facilitates this analysis by separating fixed and variable costs, making it easier to determine the break-even point and understand the impact of changes in production levels on profitability.

Margins are Less Distorted

Another advantage of variable costing is that margins are less distorted than they are under absorption costing. Because variable costing only includes variable costs in the cost of goods sold and inventory, it provides a more accurate picture of the cost of producing each unit.

Disadvantages of Variable Costing

Not Accounting for Fixed Overhead Costs

One of the main disadvantages of variable costing is that it does not account for fixed overhead costs. While these costs are expense immediately under variable costing, they are include in the cost of goods sold and inventory under absorption costing. This can make it more difficult to compare profitability between the two methods.

Not in Accordance with GAAP

Another downside of variable costing is that it does not follow Generally Accepted Accounting Standards (GAAP). GAAP requires that all costs, including fixed costs, be included in the cost of goods sold and inventory. 

May Lead to Lower Profits

Finally, variable costing may lead to lower profits compared to absorption costing. Because fixed costs are expense immediately under variable costing, it can make profits appear lower than they actually are. 

This can be problematic for businesses that rely on profits to secure financing or attract investors.

• Variable costing only focuses on variable costs for calculating the cost of a product.
• Variable costing excludes direct, fixed overhead costs.
• It is not GAAP-compliant and cannot be used for external reporting by public companies.
• Variable costing can provide a clearer picture of per-unit cost and inventory value because it excludes fixed overhead costs.
• Variable costing results in a lower breakeven price per unit using COGS, which can make it more difficult to determine the ideal pricing for a product.
• It results in a slightly higher gross profit and gross profit margin compared to absorption costing.

Managers should be aware of both methods when reviewing their company’s COGS cost accounting process and use both methods to make informed decisions.