Variable and absorption are two different costing methods.

Almost all successful companies in the world

use both the methods. Variable costing and absorption costing cannot be substituted for one another
because both the systems have their own benefits and limitations.
These costing approaches are known by various names. For example, variable costing is also known as
direct costing or marginal costing and absorption costing is also known as full costing or traditional
costing.
The information provided by variable costing method is mostly used by internal management for decision
making purposes. Absorption costing provides information that is used by internal management as well as
by external parties like creditors, government agencies and auditors etc.

Computation of unit product cost under two methods:

Under absorption costing system, the product cost consists of all variable as well as all
fixed manufacturing costs i.e., direct materials, direct labor and factory overhead (FOH). But when
variable costing system is used, the fixed cost (both manufacturing and non-manufacturing) is treated as
a period or capacity cost and is, therefore, not included in the product cost.
Following exhibition summarizes the difference between variable costing and absorption costing:
Variable versus absorption costing

For further clarification of the concept, consider the following examples:

Example 1
A company manufactures and sells 5000 units of product X per year . Suppose one unit of product X
requires the following costs:
Direct materials: $5 per unit
Direct labor: $4 per unit
Variable manufacturing overhead: $1 per unit
Fixed manufacturing overhead: $20,000 per year
The unit product cost of the company is computed as follows:
Absorption Costing
$5
$4
$1
$4*
$14
-

* $20,000 / 5,000

Variable Costing
$5
$4
$1

$10
-

Notice that the fixed manufacturing overhead cost has not been included in the unit cost under variable
costing system but it has been included in the unit cost under absorption costing system. This is the
primary difference between variable and absorption costing.

Example 2
Sunshine company produces and sells only washing machines. The company uses variable costing for
internal reporting and absorption costing for external reporting. The data for the year 2010 is given below:
Direct materials
Direct labor
variable manufacturing overhead
Fixed manufacturing overhead
Fixed marketing and administrative expenses
Variable marketing and administrative expenses

$150/unit
$45/unit
$25/unit
$160,000 per year
$110,000 per year
$15/unit sold

Company produced and sold 8,000 machines during the year 2010.
Required: Compute unite product cost under variable costing and absorption costing.

Solution
Materials
Labor
Variable overhead
Fixed overhead

Absorption Costing
$150
$45
$25
$20*
240
-

Variable Costing
$150
$45
$25

220
-

*$160,000 / 8,000 Units = $20

Note: Marketing and administrative expenses are period costs and are not relevant in the computation of
unit product cost.