Absorption Costing vs. Variable Costing: An Overview
Absorption costing and variable costing are methods used in accounting to value companies’ work in progress and inventory. Absorption costing includes all the costs associated with manufacturing a product. Variable costing includes the costs directly incurred in production and none of the fixed costs. Absorption costing is required for reporting purposes under the Financial Accounting Standards Board’s Generally Accepted Accounting Principles (GAAP).
Absorption versus variable costing will only be a factor for companies that expense costs of goods sold (COGS) on their income statements. Any company can use both methods for various reasons but public companies are required to use absorption costing due to their GAAP accounting obligations.
Key Takeaways
- Absorption costing includes all the direct costs associated with manufacturing a product.
- Variable costing can exclude some direct fixed costs.
- Absorption costing entails allocating fixed overhead costs to all units produced for an accounting period.
- Variable costing includes all the variable direct costs in COGS but it excludes direct, fixed overhead costs.
- Variable costing can provide a clearer picture of per-unit cost and inventory value because it excludes the fixed overhead cost.
Direct and Indirect Costs
Direct costs are usually associated with COGS which affects a company’s gross profit and gross profit margin. Indirect costs are associated with the operating expenses of a company. These costs heavily influence operating profit and the operating profit margin.
Some direct costs associated with manufacturing a product include wages for workers who are physically manufacturing a product, the raw materials used in producing a product, and direct overhead costs involved in manufacturing it.
Indirect expenses aren’t directly associated with manufacturing. These can include:
- Research and development
- Some depreciation
- Amortization of intangibles
- Selling expenses
- Marketing expenses
- Administrative expenses
- Other expenses
Absorption Costing
Absorption costing is also known as full costing. Public companies are required to use the absorption costing method in cost accounting management for their COGS. Many private companies also use this method because it’s GAAP-compliant and variable costing is not.
Absorption costing involves allocating to COGS all the direct costs associated with manufacturing a product. This includes any variable costs that are directly associated with manufacturing such as:
- Cost of raw materials
- Hourly cost of labor
- Salaries of manufacturing workers
- Variable costs of electricity used to run a plant in manufacturing mode
It also includes any direct fixed costs such as:
- The mortgage payment on a building used for manufacturing
- Insurance on a manufacturing property
- Depreciation on a manufacturing machine
Depending on a company’s level of transparency, an income statement using absorption costing may break variable direct costs and fixed direct costs into two line items or combine them to report a comprehensive COGS. The variable direct costs and fixed direct costs are subtracted from revenue to arrive at the gross profit in either case.
Using the absorption costing method will increase COGS and thus decrease gross profit per unit produced so companies will have a higher breakeven price on production per unit. Customers will pay a slightly higher retail price. Companies will likely show a lower gross profit margin.
The impact of absorption costing will depend on the business. A company must pay its manufacturing property mortgage payments every month regardless of whether it produces 1,000 products or no products at all. It may see an increase in gross profit after paying off the mortgage or finishing the depreciation schedule on a piece of manufacturing equipment. These are considerations that cost accountants must closely manage when using absorption costing.
The absorption costing method is typically the standard for most companies with COGS. It’s required for compliance with GAAP. Auditors and financial stakeholders will require it for external reporting. Small businesses may also be required to use absorption costing for their tax reporting depending on their type of business structure.
Note
A main advantage of absorption costing is that it’s GAAP-compliant. It’s the only method needed if it’s what a company prefers to use. A company may also be required to use the absorption costing method for reporting purposes if it prefers the variable costing method for management decision-making purposes.
Variable Costing
Some companies may choose to use the variable costing method. All the variable direct costs are included in COGS with this method. The fixed direct costs are allocated to operating expenses rather than COGS. The types of fixed direct costs are the same whether a company uses absorption or variable costing:
- A mortgage payment on a building used for manufacturing
- Insurance on a manufacturing property
- Depreciation on a manufacturing machine
Variable costing will result in a lower breakeven price per unit using COGS. This can make it somewhat more difficult to determine the ideal pricing for a product. Variable costing results in gross profit that will be slightly higher, resulting in a slightly higher gross profit margin compared to absorption costing.
Companies using the cash method may not have to recognize some of their expenses immediately with variable costing because they’re not tied to revenue recognition. This can be an advantage.
Important
Variable costing isn’t allowed for external reporting because it doesn’t follow the GAAP matching principle. It fails to recognize certain inventory costs in the same period in which revenue is generated by the expenses.
Key Differences
Both costing methods can be used by management to make manufacturing decisions. Both can also be used for internal accounting purposes to value work in progress and finished inventory.
The overall difference between absorption costing and variable costing concerns how each accounts for fixed manufacturing overhead costs.
| Absorption Costing | Variable Costing | |
| Method | Applies all direct costs, fixed overhead, and variable manufacturing overhead to the cost of a product | Only variable costs are applied to the cost of a product; fixed overhead costs are expensed in the period in which they occur |
| Use | Calculates a per-unit cost of fixed overhead | Determines a lump sum for fixed overhead costs |
| Inventory | Inventory value includes direct material, direct labor, and all overhead | Inventory value does not include fixed overhead |
| Accounting | Can cloud picture of company profitability for an accounting period because all fixed costs are not deducted from revenues (unless all inventory is sold) | Doesn’t match expenses to revenue with regard to inventory in the same accounting period; may result in a more realistic inventory value and actual profit because unsold stock doesn’t absorb fixed overhead costs |
| Reporting | Acceptable costing method under GAAP | Not an acceptable costing method under GAAP |
Absorption Costing vs. Variable Costing Example
Let’s say that ABC Company manufactures and sells 20,000 units of its product yearly. A single product includes these costs:
- Direct materials: $3 per unit
- Direct labor: $5 per unit
- Variable manufacturing overhead: $2 per unit
- Fixed manufacturing overhead: $35,000 per year which computes to a $1.75 per unit cost ($35,000/20,000 annual units)
Under the absorption costing method, the per unit cost of the product would be:
$3 + $5 + $2 + $1.75 = $11.75
Under the variable costing method, the per unit cost of the product would be:
$3 + $5 + $2 = $10
Is Variable Costing More Useful Than Absorption Costing?
It can be more useful, especially for management decision-making concerning break-even analysis to derive the number of product units that must be sold to reach profitability.
What Are the Advantages of Variable Costing?
Variable costing doesn’t add fixed overhead costs into the price of a product so it can give a clearer picture of costs. These costs are hidden in inventory and don’t appear on the income statement when assigning these fixed costs to the cost of production, as absorption costing does.
What Are the Disadvantages of Variable Costing?
Variable costing is a valuable management tool but it isn’t GAAP-compliant and it can’t be used for external reporting by public companies. A company may also have to use absorption costing which is GAAP-compliant if it uses variable costing.
The Bottom Line
Most companies will use the absorption costing method if they have COGS and it may be required for external reporting purposes because it’s the only method that complies with GAAP. Companies may decide that absorption costing alone is more efficient to use.
It may be beneficial to use the variable costing method depending on a company’s business model and reporting requirements or at least calculate it in dashboard reporting. Managers should be aware that both absorption costing and variable costing are options when reviewing their company’s COGS cost accounting process.
It can make a big impact on the per-unit price if a company has high direct, fixed overhead costs. Companies that use variable costing may be able to allocate high monthly direct, fixed costs to operating expenses. This could result in a more reasonable per-unit price in some cases. Most companies may have to transition to absorption costing at some point, however, and it can be important to factor this into short-term and long-term decision-making.
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