Variable Costing Vs. Absorption Costing
In a manufacturing environment, two commonly used cost measurement methods are variable (or direct) costing, and absorption costing. Each method offers a slightly different perspective and has unique benefits and limitations, and thus can be used to fulfill various reporting and management objectives.
Manufacturing costs contain both variable and fixed components. Variable cost components include variable manufacturing costs (direct materials, direct labor, and variable manufacturing overhead) and variable selling and administrative costs. These costs are deemed ‘variable’ because they vary as production volume varies and are considered a product (or per unit) cost. Fixed cost components include fixed manufacturing overhead costs (rents, manager salaries, depreciation, etc.) and fixed selling and administrative costs. These costs are deemed ‘fixed’ because they generally do not change as production volume changes and are considered period costs that are expensed on the income statement in the period they are incurred. In both variable and absorption costing, fixed and variable selling and administrative costs are treated as period costs and are expensed as incurred. The treatment of fixed overhead costs is where variable and absorption costing differ.
When utilizing the variable costing approach, only variable manufacturing costs are considered product costs that are recognized on the income statement. Fixed manufacturing overhead costs are reported on the balance sheet as inventory, which generates lower cost of goods sold and inventory carrying costs on the income statement. The primary limitations of variable costing are that it can be time consuming and costly to separate variable and fixed cost components, and it does not comply with US GAAP and consequently cannot be used for external or tax reporting. However, it can be a useful management and decision-making method for analyses such as cost-volume-profit (CVP) analysis which analyzes the impact of changes in sales volume on profitability.
When applying the absorption costing approach, both variable manufacturing costs and fixed manufacturing overhead costs are considered product costs that are recognized on the income statement as costs of inventory. This results in higher cost of goods sold and inventory carrying costs on the income statement. The primary benefit of absorption costing is that it complies with US GAAP and therefore is required for external and tax reporting. Its main limitation, however, is that it is not a reliable internal management analysis and decision-making method for analyses such as cost-volume-profit analysis.