Difference between absorption costing and variable costing methods pertains mainly to the allocation of manufacturing costs and its effect on reporting of net income. Both absorption and variable cost methods are based on accrual concept of accounting and are recognized as when they are incurred.
Under absorption costing method, sales and marketing expenses are treated as period cost and hence expenses are recorded as and when incurred. In variable costing method, product cost includes just the direct costs and variable manufacturing costs; while in absorption cost accounting, product cost also includes fixed manufacturing overheads. Thus, fixed costs are treated as a part of the production system in absorption costing.
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Understanding Difference in Fixed Cost Expensing with an Example
Let’s say a company ‘A’ manufactures 1000 pieces of pencil each year. The cost associated with manufacturing one such pencil is as follows:
|Direct Materials Cost (Per Unit)||$1.00|
|Direct Labor Cost (Per Unit)||$0.50|
|Variable Manufacturing Cost Per Unit||$0.80|
|Fixed Manufacturing Cost Per Year||$1,000.00|
|Fixed Manufacturing Cost Per Unit||$1.00|
Under the above assumptions, per unit product cost of each pencil can be calculated as follows under absorption costing as well as variable costing.
|Per Unit Cost||Absorption Costing||Variable Costing|
|Direct Materials Cost||$1.0||$1.0|
|Direct Labour Cost||$0.5||$0.5|
|Variable Manufacturing Cost||$0.8||$0.8|
|Fixed Manufacturing Cost||$1.0||–|
Variable cost accounting leads to a lower product cost. Companies relying solely on variable cost accounting should not be under the impression that the price of a product is lower and hence the project seems viable. Rather, they need to ensure that they price the goods properly and show the correct accounts as per accounting standards.
Resulting Difference in Net Income
If the Company A sell a total of 800 pencils each year with per unit sale price of $5, the net income difference based on different costing methods would be as follows:
|Income Statement||Absorption Costing||Variable Costing|
|Sales (800 * $5)||$4,000.0||$4,000.0|
|Cost of goods sold|
|Total Units Manufactured (1000)||-$3,250.0||-$2,250.0|
|Plus Ending Inventory (1000-800)||$650.0||$450.0|
|Less: Fixed Costs, incl. SG&A||$0.0||-$1,000.0|
|Less: Tax @ 20%||-$280.0||-$240.0|
Thus, income reporting differs under both cost accounting methods. Based on the above example, we can clearly note that under variable cost accounting method, the company usually ends up with lower net income. The reason behind this is that all the fixed manufacturing costs are expensed in the same year, in which they are incurred. However, absorption cost accounting can also lead to inflated profitability and hence requires careful judgment when analyzing profitability.
Variable cost accounting is useful for internal management’s decision making purposes. On the other hand, absorption cost accounting is useful for creditors, government agencies, suppliers as well as for the internal management. Absorption cost is also useful when the company doesn’t end up selling all of its manufactured goods and as a result, creates inventory. This helps some cost base to be shifted to inventory.1–3