Question

In at least 250 words, explain the key similarities and differences between absorption costing and variable costing. Be specific!

Answer 1

Under absorption costing, the product cost consists of direct materials, direct labor, variable manufacturing overheads, and fixed manufacturing overheads. However, under variable costing the product cost includes only direct materials, direct labor, and variable manufacturing overheads. The fixed manufacturing overheads are excluded from the product cost and expensed out in the period in which incurred under variable costing.

Selling and administrative expenses under both absorption costing and variable costing, are excluded from the product cost. The variable and fixed selling and administrative expenses are treated as period costs and expensed out as and when incurred under both absorption and variable costing.

Due to the difference in components of product cost under the two costing methods, the net operating income under both methods is different for the same level of activity unless the production is exactly equal to sales and there are no beginning or ending inventories. Profit is not affected by changes in inventory under variable costing which is not so for absorption costing.

Absorption costing is based on the premise that fixed manufacturing costs must be assigned to products for proper matching of revenues and costs. It thus conforms to GAAP and is used for external financial reporting purposes. Also for income tax purpose, absorption costing must be used. However, absorption costing since it considers the fixed manufacturing overhead as a product cost does not support Cost-Volume-Profit analysis and decision making for which variable costing is better suited. Variable costing on the other hand is based on the premise that fixed manufacturing costs are incurred irrespective of the level of activity and are hence capacity costs. Variable costing is more useful to management for CVP analysis, flexible budgeting, estimating product or segment profitability. Thus, absorption costing is used for external reporting purposes while variable costing is used for internal analysis and decision making.

(Total words: 304)