Before discussing Variable and Absorption costing will

have first a:

Quick Review on the topic:

Variable Cost and Fixed Cost

A variable cost is a corporate expense that changes in proportion to production output. Variable
costs increase or decrease depending on a company's production volume; they rise as production
increases and fall as production decreases. Examples of variable costs include the costs of raw
materials and packaging.

Variable cost can be contrasted with fixed cost.

Variable Costs

KEY TAKEAWAYS

A variable cost is a corporate expense that changes in proportion with production output.

Variable costs are dependent on production output.

A variable cost can increase or decrease depending on several factors, as opposed to a fixed cost
which is one-time or constant.

Understanding a Variable Cost

The total expenses incurred by any business consist of fixed costs and variable costs.

FIXED COST

Fixed costs are expenses that remain the same regardless of production output. Whether a firm
makes sales or not, it must pay its fixed costs, as these costs are independent of output.

Examples of fixed costs are rent, employee salaries, insurance, and office supplies. A company
must still pay its rent for the space it occupies to run its business operations irrespective of the
volume of product manufactured and sold. Although fixed costs can change over a period of
time, the change will not be related to production.

Variable costs, on the other hand, are dependent on production output. The variable cost of
production is a constant amount per unit produced. As the volume of production and output
increases, variable costs will also increase.
Conversely, when fewer products are produced, the variable costs associated with production
will consequently decrease. Examples of variable costs are sales commissions, direct labor costs,
cost of raw materials used in production, and utility costs. The total variable cost is simply the
quantity of output multiplied by the variable cost per unit of output.

There is also a category of costs that falls in between, known as semi-variable costs (also known
as semi-fixed costs or mixed costs). These are costs composed of a mixture of both fixed and
variable components. Costs are fixed for a set level of production or consumption and become
variable after this production level is exceeded. If no production occurs, a fixed cost is often still
incurred.

VARIABLE AND ABSORPTION COSTING

Explain the difference between variable and absorption costing. How unit product cost is
computed under two methods?

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

Variable Costing: $5 + $4 + $1 = $10

* $20,000 / 5,000

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
2016 is given below:

Direct materials: $150/unit
Direct labor: $45/unit
Variable manufacturing overhead: $25/unit
Fixed manufacturing overhead: $160,000 per year
Fixed marketing and administrative expenses: $110,000 per year
Variable marketing and administrative expenses: $15/unit sold

Company produced and sold 8,000 machines during the year 2016.

Required: Compute the unite product cost under variable costing and absorption costing.

Solution:

*$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.

Variable Costing vs Absorption

Costing
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Costing
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
 

Key Differences
It is important to gauge the key differences between these costing. This will
give us additional clarity on the subject matter.

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 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 and 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.

 
Variable vs Absorption Costing Comparative Table
Basis Variable Costing Absorption Costing

Variable costing includes only variable Absorption costing includes both variable
Costs
costs directly incurred in production. costs and fixed costs related to production.

Alternative Names Variable costing is also known Absorption costing is also known as full
 as marginal costing or direct costing. costing.

Absorption costing is used for reporting to the

Variable costing is generally used for external stakeholders as well as for the

Internal / External internal reporting purposes. Managerial purpose of filing taxes. It is in line

Use decisions are taken on the basis of with GAAP (Generally Accepted Accounting

variable costing. Principles) and IFRS (International Financial

Reporting Standards).

Variable costing is used for comparing

the profitability of different product Absorption costing is used for calculating per

Relevance lines. The organization can carry out an unit cost based on all costs including fixed

analysis based on costs, volumes, and overhead costs.

profits.

Variable costing is based on internal Absorption costing is based on external

Reporting specifications of reporting and reporting standards given by external

presentation. agencies.

Variable costing involves only variable

Absorption costing involves considering all
production costs to be assigned to
Inventory production costs and including them in
inventory, work-in-progress and cost of
inventory and work-in-progress.
goods sold.

Variable costing calculates contribution

Absorption costing is used to calculate the net
Contribution which is the difference between sales
profit.
and variable cost of sales.

Profit is much easier to predict as it is a It is much more difficult to predict the effect
Profit
function of sales. of change in sales on profit.
 

Conclusion
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.