This week in Managerial Accounting, I learned about Variable and Absorption costing.
Variable costing is when you only take into account the manufacturing costs that vary with output. This includes direct materials, direct labor, and the variable portions of manufacturing overhead. Under this method, fixed manufacturing overhead is not treated as a product cost but rather is incurred the period that a product is produced.
Absorption costing is when you treat all manufacturing costs as product costs, regardless of whether they are variable or fixed. This includes direct materials, direct labor, and both the variable and fixed portions of manufacturing overhead. Because absorption costs includes all manufacturing costs in product costs, it is frequently referred to as the full cost method. Sometimes, the net income under absorption costing can be higher than that calculated by variable because the product costs is capitalized in the inventory until sold.
An example of setting up an income statement for the two cost methods:
From what I can gather, both methods have their benefits and drawbacks.
The advantage of absorption costing is that:
- It hides details when you need to report to external investors.
- It takes into account indirect costs.
- And some argue that it paints a more accurate picture of a company's economic health.
The disadvantage of absorption costs is that:
- Because it bundles fixed and variable costs into the same product, it can be difficult to truly discern what is a product "cost."
- You can also hide costs in the inventory to make net income larger.
- If fixed overhead costs vastly exceed variable costs, it can be hard to see the effects of production decisions.
- Fixed cost effect is transparent on the income statement.
- Takes into account total cost of investments. When you finally sell your products, you may experience surplus net income.
- Enables cost volume profit analysis.
- Clear income statement
- Correctly identifies variable cost effects
The disadvantage of variable costing is that:
- Difficulty separating fixed and variable costs
- Loads costs heavily early on. Even if you don’t sell all the products you make, you must deduct the full cost of fixed overhead.
- Not GAAP.