Question

Explain the difference between variable costing and absorption costing. Describe the limitations of using variable costing. Describe the limitations of using absorption costing. What difference do you notice on the income statement when prepared with absorption costing versus variable costing?

"Managerial Accounting"

Answer 1

Difference between absorption costing and variable costing:

Variable costing	Absorption costing
(1) Only variable costs are considered for Product costing and Inventory valuation	(1) Both fixed and variable costs are considered for Product costing and Inventory valuation
(2) Fixed costs are considered as period costs. The profitability of different product is judged by their profit volume ratio	(2)Fixed costs are charged to the cost of production. Each product bears a reasonable share of fixed cost and thus the profitability of a product is influenced by the apportionment of fixed cost
(3) Variable costing prepared for internal users, it is used by the management for decision making purpose	(3) Absorption costing is prepared for external users, such as stockholders, borrower etc.
(4) Cost data are presented in conventional pattern. Net profit of each product is determined after subtracting fixed cost with their variable cost	(4) Cost data are presented to highlight the total Contribution of each product.
In absorption costing cost per reduces as the Production volume increases because fixed cost reduces per unit, when Production volume increases and variable cost per unit remain same,thereby total cost per unit reduces as Production volume increases.	(5) In variable costing the cost per unit remain same, irrespective of production volume increases because it is valued at Variable cost only .

Limitations of variable costing and Absorption costing:

Variable costing

(1) Separation of cost into fixed and variable presents technical difficulties.

(2) Under variable costing stock of finished goods and work in process are understated. Fixed cost are incurred in order to manufacture products and these should form a part of the cost of Product

(3) Variable costing does not give full information

(4) For short term assessment of profitability marginal cost may be useful but long term profit is correctly determined by the absorption costing.

(5) with increased automation and technological development the impact on fixed costs on Production is much more than variable cost. A system which ignores fixed cost is less effective.

Absorption costing

(1) Dependent on level of output which vary from period to period.

(2) Profit and loss in the accounts are related not only to sales but also to Production, due to carry over of a portion of fixed cost to subsequent accounting period as part of the cost of Inventory.

(3) There is no uniformity in the method of application of overhead in absorption costing.

(4) Absorption costing is not suitable for decision making purpose.

Difference in income statement in Variable costing and Absorption costing:

Variable costing	Absorption costing
(1) In variable costing contribution margin is computed	(1)In absorption costing Gross profit margin is computed contribution margin is not computed
(2) Only variable direct cost is associated with cost of goods manufactured	(2)Both fixed and variable direct cost is associated with cost of goods manufactured
(3) Net income is same as it is in Absorption costing	(3) Net income is same as it is in Variable costing

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