Difference Between Variable and Absorption Costing
Variable cost is the accounting method in which all the variable production costs are only included in product cost whereas Absorption costing is where all the absorbed costs are taken into account and under this method, all the fixed and variable production costs are deducted and then fixed and variable selling expenses are deducted.
Variable costing is defined as an accounting method for production expenses where only variable costs are included in the product cost, whereas, Absorption costing includes all costs associated with a production process that is assigned to the units produced.
- Variable costing consists of direct material costs, direct labor costs, and variable manufacturing overheads, whereas, Absorption costing consists of direct material costs, direct labor costs, variable manufacturing overheads, and fixed manufacturing overheads.
- Under variable costing, there is no concept of over and under absorption of overheads. Under absorption costing, fixed costs are absorbed on an actual basis, or on the basis of the predetermined rate based on normal capacity.
Variable vs Absorption Costing Infographics
It is important to gauge the key differences between these costing. This will give us additional clarity on the subject matter.
- The key difference will be clear through an example. Let us assume that an organization makes 1000 units of a product. It incurs Rs.2 for direct material, Rs.1 for direct labor, and Rs.2 for variable factory overhead. It additionally incurs a fixed factory overhead of Rs.1000. Here, the product cost under variable costing will be Rs.5 (2+1+2). Under absorption costing fixed factory overhead of Rs.1000 will also be allocated over 1000 units, working out to Rs.1 per unit. Thus, the product cost under absorption costing will be Rs.6 (5+1).
- Now let us see how variable costing helps in taking managerial decisions. Suppose the organization gets an order of 50 additional units of a product at Rs.5.50 per unit selling price. No additional cost would be incurred on the order. Should the company accept the order? Based on absorption costing, the company might reject the order as a loss of Rs.0.50 (5.50-6) per unit is made. But, fixed factory overhead won’t increase for producing additional units. Hence, the decision to reject the order is flawed. Based on variable costing profit would be Rs.0.5 (5.50-5). Hence, the organization should accept the order based on variable costing, which is the right decision.
- Variable costing is used for taking managerial decisions such as which product to discontinue, determining product-mix, make or buy decisions, and how to price a product. In addition, variable costing is used for finding a margin of safety, optimal capacity utilization rate, and the degree of operating leverage. Variable costing is used for calculating the break-even point based on the cost-volume-profit analysis. The break-even point is the level where there are no profits/losses. Variable costing helps in determining the contribution margin of a product. Absorption costing does not help in taking these managerial decisions. But, the pricing policy determined in accordance with absorption costing ensures that all costs are covered.
- Since absorption costing is to be utilized for external reporting, it may be used as the sole method of accounting. Thus, an organization can completely do away with variable costing. This will help it reduce the burden of accounting. But if it does so, it will miss out on certain key insights available from variable costing. Variable costing is not recognized for external reporting as it does not uphold the matching principle with regard to inventory. Undermatching principle, related expenses should be recognized in the same period as related revenue. The supporters of variable costing argue that no fictitious profit can arise due to the fixed cost being absorbed in stock which is unsold. This leads to a realistic valuation of a stock.
- In absorption costing, since a considerable amount of overhead costs are allocated to the product, a significant proportion of the product’s cost may not be directly traceable to the product. The management can also push forward costs to the subsequent period when the products are sold. Under absorption costing, managers can improve their profit performance by building up inventory. This does not reveal an accurate picture. One of the limitations of variable costing is that it becomes very difficult and cumbersome to apply in cases where there are large stocks of work-in-progress inventory.
Variable vs Absorption Costing Comparative Table
|Basis||Variable Costing||Absorption Costing|
|Costs||Variable costing includes only variable costs directly incurred in production.||Absorption costing includes both variable costs and fixed costs related to production.|
|Alternative Names||Variable costing is also known as marginal costing or direct costing.||Absorption costing is also known as full costing.|
|Internal / External Use||Variable costing is generally used for internal reporting purposes. Managerial decisions are taken on the basis of variable costing.||Absorption costing is used for reporting to the external stakeholders as well as for the purpose of filing taxes. It is in line with GAAP (Generally Accepted Accounting Principles) and IFRS (International Financial Reporting Standards).|
|Relevance||Variable costing is used for comparing the profitability of different product lines. The organization can carry out an analysis based on costs, volumes, and profits.||Absorption costing is used for calculating per unit cost based on all costs including fixed overhead costs.|
|Reporting||Variable costing is based on internal specifications of reporting and presentation.||Absorption costing is based on external reporting standards given by external agencies.|
|Inventory||Variable costing involves only variable production costs to be assigned to inventory, work-in-progress, and cost of goods sold.||Absorption costing involves considering all production costs and including them in inventory and work-in-progress.|
|Contribution||Variable costing calculates contribution which is the difference between sales and variable cost of sales.||Absorption costing is used to calculate the net profit.|
|Profit||Profit is much easier to predict as it is a function of sales.||It is much more difficult to predict the effect of change in sales on profit.|
Though variable costing aids in managerial decisions, it should not be the sole basis for managerial decisions. The management should look at different perspectives including looking at absorption costing data. The management should look at consumer insights, relation with buyers, the effect on brand-building, and other factors while taking decisions. While calculating net profit, a manager should look at both costing techniques.
This has been a guide to Variable Costing vs Absorption Costing. Here we discuss top differences between them along with infographics and comparison table. You may also have a look at the following articles –