Question

Explain the difference between absorption costing and variable costing methods. How does each treat fixed manufacturing overhead? Provide an example and calculate the unit product cost using each method.

Answer 1

Absorption vs. variable costing will only be a factor for companies that expense costs of goods sold (COGS) on their income statement. Absorption vs. variable costing is not optional for public companies because they are required to use absorption costing due to their GAAP accounting obligations.

Absorption costing includes all of the direct costs associated with manufacturing a product, while variable costing can exclude some direct fixed costs.

Absorption costing, also known as full costing, entails allocating fixed overhead costs across all units produced for the period, resulting in a per-unit cost.

Variable costing includes all of the variable direct costs in COGS but excludes direct,fixed overhead costs.

Most companies will use the absorption costing method if they have COGS. For many companies, managers will find that they are required under GAAP to use absorption costing and therefore find it most efficient to use this method only.

Depending on a company’s business model and reporting requirements, it may be beneficial to use the variable costing method, or at least calculate it in dashboard reporting. Overall, managers should be aware that absorption costing and variable costing are available as options when reviewing their company’s COGS cost accounting process.

If a company has high direct, fixed overhead costs it can make a big impact on the per unit price. Companies that use variable costing may be able to allocate high monthly direct, fixed costs to operating expenses. This could result in a more reasonable per unit price in some cases. However, most companies will need to transition to absorption costing at some point, which can be important to factor into short-term and long-term decision making.