Definition and explanation:
Absorption costing is a costing system which treats all costs of production as product costs, regardless weather they are variable or fixed. The cost of a unit of product under absorption costing method consists of direct materials, direct labour and both variable and fixed overhead. Absorption costing allocates a portion of fixed manufacturing overhead cost to each unit of product, along with the variable manufacturing cost. Because absorption costing includes all costs of production as product costs, it is frequently referred to as full costing method.
VARIABLE, DIRECT OR MARGINAL COSTING:
Definition and explanation:
Variable costing is a costing system under which those costs of production that vary with output are treated as product costs. This would usually include direct materials, direct labour 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.
Absorption Costing and Variable Costing Compared:
The only difference between absorption costing and variable costing is the treatment of fixed manufacturing overhead (FMOH). Under absorption costing, FMOH is allocated to units produced, so that there is a little bit of FMOH included in the cost of every unit of inventory. Under variable costing, FMOH is treated as a period expense, appearing on the income statement as a lump-sum in the period incurred.
Comparing income under absorption costing to income under variable costing, the following observations can be made:
– When there are beginning and ending inventories, absorption costing and variable costing will generally result in different inventory valuations for beginning inventory, different inventory valuations for ending inventory, and different incomes, but it is possible for the inventory balances and income to be the same under the two methods.
– If beginning and ending inventory levels are zero, absorption costing and variable costing will always result in the same income.
– If beginning inventory is zero and ending inventory is positive, absorption costing will always result in higher income than variable costing, and a higher valuation for ending inventory.
– If beginning inventory is positive and ending inventory is zero, absorption costing will always result in lower income than variable costing, and a higher valuation for beginning inventory.
– When inventory levels are increasing from period-end to period-end, as would be expected when the company is growing, absorption costing will generally result in higher ending inventory valuations than variable costing, and also higher income in each period. The reason is that absorption costing postpones recognizing ever-increasing amounts of fixed manufacturing overhead on the income statement, because increasing amounts of fixed manufacturing overhead are capitalized as ending inventory.
Over the life of the company (or from any point in time at which there is zero inventory to any other point in time at which there is zero inventory), the sum of income over all periods must be equal under the two methods. The difference between absorption costing and variable costing is only a timing difference: the question of when fixed manufacturing overhead is taken to the income statement