Question

What is the difference between absorption costing and variable costing, and how can the choice between these two methods impact a company's reported profits and financial performance?

Answer 1

Absorption costing and variable costing are two methods used in managerial accounting to allocate costs to products or services. The main difference between these two methods lies in how they treat fixed manufacturing overhead costs. Absorption costing is a method that assigns all manufacturing costs, both variable and fixed, to the product being produced. Under absorption costing, fixed manufacturing overhead costs, such as rent, salaries, and depreciation, are included in the cost of goods sold (COGS) calculation. This means that the more products a company produces, the lower its fixed manufacturing overhead cost per unit, and the higher its reported profits. Variable costing, on the other hand, only assigns variable manufacturing costs to the product being produced. Fixed manufacturing overhead costs are treated as period costs and are expensed in the period in which they are incurred. This means that the more products a company produces, the higher its fixed manufacturing overhead cost per unit, and the lower its reported profits. The choice between absorption costing and variable costing can impact a company's reported profits and financial performance. In periods of increasing production, absorption costing will result in higher profits than variable costing due to the lower fixed manufacturing overhead cost per unit. Conversely, in periods of decreasing production, variable costing will result in higher profits than absorption costing due to the higher fixed manufacturing overhead cost per unit. The choice between absorption costing and variable costing can also impact a company's inventory valuation. Under absorption costing, inventory values include fixed manufacturing overhead costs, while under variable costing, they do not. This can impact a company's financial performance and tax liabilities.

In summary, the choice between absorption costing and variable costing can impact a company's reported profits, financial performance, and inventory valuation. It is important for companies to understand the differences between these two methods and select the one that best aligns with their business goals and objectives.

the choice between absorption costing and variable costing can impact a company's reported profits, financial performance, and inventory valuation