Variable Costing vs Absorption Costing

Variable cost is the accounting method in which all the variable production costs are only included in product cost. In contrast, Absorption costing is where all the absorbed costs are taken into account. Under this method, all the fixed and variable production costs are deducted, and then fixed and variable selling expenses are deducted.

Variable costing is an accounting method for production expenses where only variable costs are included in the product cost. In contrast, Absorption costing includes all costs associated with a production process assigned to the units produced.

• Variable costing consists of direct material costs, direct labor costs, and variable manufacturing overheads, whereas, Absorption costing consists of direct material costs, direct labor costs, variable manufacturing overheads, and fixed manufacturing overheads.
• Under variable costing, there is no concept of over and under absorption of overheads. Under absorption costing, fixed costs are absorbed on an actual basis, or on the basis of the predetermined rate based on normal capacity.

It is important to gauge the key differences between these costing. This will give us additional clarity on the subject matter.

• The key difference will be clear through an example. Let us assume that an organization makes 1000 units of a product. It incurs Rs.2 for direct material, Rs.1 for direct labor, and Rs.2 for variable factory overhead.  It additionally incurs a fixed factory overhead of Rs.1000. Here, the product cost under variable costing will be Rs.5 (2+1+2). Under absorption costing, fixed factory overhead of Rs.1000 will also be allocated over 1000 units, increasing to Rs.1 per unit. Thus, the product cost under absorption costing will be Rs.6 (5+1).
• Now let us see how variable costing helps in making managerial decisions. Suppose the organization gets an order of 50 additional units of a product at Rs.5.50 per unit selling price. No additional cost would be incurred on orders. Should the company accept the order? The company might reject the order based on absorption costing as a loss of Rs.0.50 (5.50-6) per unit is made. But, fixed factory overhead won’t increase for producing additional units. Hence, the decision to reject the order is flawed. The profit would be Rs.0.5 (5.50-5) based on variable costing. Hence, the organization should accept the order based on variable costing, which is the right decision.
• Variable costing is used to make managerial decisions such as which product to discontinue, determine product mix, make or buy decisions, and how to price a product. In addition, variable costing is used for finding a margin of safety, optimal capacity utilization rate, and the degree of operating leverage. Variable costing is used for calculating the break-even point based on the cost-volume-profit analysis. The break-even point is the level where there are no profits/losses. Variable costing helps in determining the contribution margin of a product. Absorption costing does not help in making these managerial decisions. But, the pricing policy determined following absorption costing ensures that all costs are covered.
• Since absorption costing is to be utilized for external reporting, it may be used as the sole method of accounting. Thus, an organization can completely do away with variable costing. This will help reduce the burden of accounting. But if it does so, it will miss out on certain key insights available from variable costing. Variable costing is not recognized for external reporting as it does not uphold the matching principle about inventory. Undermatching principle, related expenses should be recognized in the same period as related revenue. The supporters of variable costing argue that no fictitious profit can arise due to the fixed cost being absorbed in unsold stock. This leads to a realistic valuation of a stock.
• In absorption costing, since a considerable amount of overhead costs are allocated to the product, a significant proportion of the product’s cost may not be directly traceable to the product. The management can also push forward costs to the subsequent period when the products are sold. Under absorption costing, managers can improve their profit performance by building up inventory. This does not reveal an accurate picture. One of the limitations of variable costing is that it becomes very difficult and cumbersome to apply in cases where there are large stocks of work-in-progress inventory.

Though variable costing aids in managerial decisions, it should not be the sole basis. The management should look at different perspectives, including absorption costing data. The management should look at consumer insights, relation with buyers, the effect on brand-building, and other factors while making decisions. While calculating net profit, a manager should look at both costing techniques.

This has been a guide to Variable Costing vs. Absorption Costing. Here we discuss the top differences between them and infographics and a comparison table. You may also have a look at the following articles –

• What is Semi Variable Cost?
• Cost Product Examples
• Indirect Costs Meaning
• Job Costing vs Process Costing