Variable Costing Versus Absorption Costing:
Absorption Costing or Full Costing System:
Definition and explanation:
Under absorption costing system, all
costs of production (both variable and fixed) are treated as product costs. The
unit product cost consists of direct materials, direct labor and both variable
and fixed overhead. When absorption costing method is used a portion of fixed
manufacturing overhead cost is allocated to each unit of product along with
variable manufacturing cost. This approach is also called full costing
method because all costs of production are included in the product cost.
Variable/Direct/Marginal Costing System:
Definition and explanation:
Under variable costing system, those
costs of production that vary with output are treated as product costs. The unit
product costs under variable costing system consists of direct materials, direct
labor and variable portion of manufacturing overhead. Fixed manufacturing cost
is not treated as a product costs under variable costing. Rather, fixed
manufacturing cost is treated as a period cost and, like selling and
administrative expenses, it is charged off in its entirety against revenue each
period. Consequently the cost of a unit of product in inventory or cost of goods
sold under this method does not contain any fixed overhead cost. Variable
costing is some time referred to as direct costing or
marginal costing.
To complete this summary comparison of
absorption and variable costing, we need to consider briefly the handling of
selling and administrative expenses. These expenses are never treated as product
costs, regardless of the costing method in use. Thus under either absorption or
variable costing, both variable and fixed selling and administrative
expenses are always treated as period costs and deducted from revenues as
incurred.
Difference
between variable and absorption costing is illustrated below
Cost classifications -
Absorption versus variable costing |
Absorption
Costing |
|
Variable
Costing |
Product cost |
Direct
materials
Direct Labor
Variable Manufacturing overhead |
Product cost |
Fixed
manufacturing overhead |
Period cost |
Period cost |
Variable
selling and administrative expenses |
Fixed
selling and administrative expenses |
Unit Cost Computation:
To illustrate the calculation of
unit product cost under both absorption and variable costing consider the
following example:
Example:
A small company that produces a
single product has the following cost structure.
Number of units produced |
6,000 |
Variable costs per unit: |
Direct materials |
$2 |
Direct labor |
$4 |
Variable manufacturing overhead |
$1 |
Variable selling and Administrative expenses |
$3 |
Fixed costs per year: |
Fixed manufacturing overhead |
$30,000 |
Fixed selling and administrative expenses |
$10,000 |
Required:
- Compute the unit product cost under
absorption costing method.
- Compute the unit product cost under
variable/marginal costing method.
Unit product Cost
Absorption Costing Method |
Direct materials |
$2 |
Direct labor |
$4 |
Variable manufacturing overhead |
$1 |
|
|
Total variable production cost |
$7 |
Fixed manufacturing overhead ($30,000/6,000
units) |
$5 |
|
|
Unit product cost |
$12 |
|
|
Unit product Cost
Variable Costing Method |
Direct materials |
$2 |
Direct labor |
$4 |
Variable manufacturing overhead |
$1 |
|
|
Unit product cost |
$7 |
|
|
(The $30,000 fixed manufacturing overhead will be charged off in total
against income as a period expense along with selling and administrative
expenses) |
Under the absorption costing,
notice that all production costs, variable and fixed, are included when
determining the unit product cost. Thus if the company sells a unit of
product and absorption costing is being used, then $12 (consisting of $7
variable cost and $5 fixed cost) will be deducted on the income statement as
cost of goods sold. Similarly, any unsold units will be carried as inventory on
the balance sheet $12 each.
Under variable costing, notice
that all variable costs of production are included in product costs. Thus if the
company sells a unit of product, only $7 will be deducted as cost of goods sold,
and unsold units will be carried in the balance sheet inventory account at only
$7.
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