What are the differences between the absorption costing income and the variable costing income for these two years?

Absorption costing is a costing method in which all costs attributed to the production of a product are estimated. This costing method entails a full estimation of total expenses incurred in manufacturing a product.

Table of Contents Show

Absorption Costing vs. Variable Costing
Impact of Absorption Costing and Variable Costing on Profit
Advantages of Using Variable Costing
Advantages of Absorption Costing
Disadvantages of Absorption Costing
Key Differences
Variable vs Absorption Costing Comparative Table
Recommended Articles

Direct costs such as costs of procuring raw materials, labor wages and indirect costs such as costs of acquiring a facility, utility costs and others are calculated in absorption costing. The absorption costing method accumulates all costs of a finished product including overhead costs and direct costs.

Under U.S. GAAP, all non-manufacturing costs (selling and administrative costs) are treated as period costs because they are expensed on the income statement in the period in which they are incurred.

Although absorption costing is used for external reporting, managers often prefer to use an alternative costing approach for internal reporting purposes called variable costing.

Variable costing requires that all variable production costs be included in inventory, and all fixed production costs (fixed manufacturing overhead) be reported as period costs.

Thus all fixed production costs are expensed as incurred.

The only difference between absorption costing and variable costing is in the treatment of fixed manufacturing overhead.

Using absorption costing, fixed manufacturing overhead is reported as a product cost.

Using variable costing, fixed manufacturing overhead is reported as a period cost.

Back to: ACCOUNTING, TAX, & REPORTING

Absorption Costing vs. Variable Costing

Absorption costing and variable costing are two distinct methods of assigning costs to the production of goods and services.

The difference between absorption costing and variable costing is in the treatment of fixed manufacturing overhead costs.

Absorption costing treats fixed manufacturing overhead as a product cost (included in inventory on the balance sheet until sold), while variable costing treats fixed manufacturing overhead as a period cost (expensed on the income statement as incurred).

When comparing absorption costing with variable costing, the following three rules apply:

(1) When units produced equals units sold, profit is the same for both costing approaches.

(2) When units produced is greater than units sold, absorption costing yields the highest profit.

(3) When units produced is less than units sold, variable costing yields the highest profit.

Impact of Absorption Costing and Variable Costing on Profit

If a company uses just-in-time inventory, and therefore has no beginning or ending inventory, profit will be exactly the same regardless of the costing approach used.

However, most companies have units of product in inventory at the end of the reporting period.

Since absorption costing includes fixed manufacturing overhead as a product cost, all products that remain in ending inventory (i.e., are unsold at the end of the period) include a portion of fixed manufacturing overhead costs as an asset on the balance sheet.

Since variable costing treats fixed manufacturing overhead costs as period costs, all fixed manufacturing overhead costs are expensed on the income statement when incurred.

Thus if the quantity of units produced exceeds the quantity of units sold, absorption costing will result in higher profit.

Advantages of Using Variable Costing

Variable costing provides managers with the information necessary to prepare a contribution margin income statement, which leads to more effective cost-volume-profit (CVP) analysis.

By separating variable and fixed costs, managers are able to determine contribution margin ratios, break-even points, and target profit points, and to perform sensitivity analysis.

Conversely, absorption costing meets the requirements of U.S. GAAP, but is not as useful for internal decision-making purposes.

Another advantage of using variable costing internally is that it prevents managers from increasing production solely for the purpose of inflating profit.

However, in the short run, the manager will increase profit by increasing production.

This strategy does not work with variable costing because all fixed manufacturing overhead costs are expensed as incurred, regardless of the level of sales.

Advantages of Absorption Costing

The use of the absorption costing method comes with a lot of benefits. The major benefits of this costing method include;

Absorption costing method reflects fixed costs that are attributable to the production of goods and services. It identifies the necessity of fixed costs when estimating costs involved in production.
It is a more accurate costing method when compared to other traditional costing methods and even its counterpart; variable costing.
Absorption costing also account for the expenses of unsold products, this is important for external reporting as required by GAAP.
This method achieves a better and higher net income estimation. This is because it helps to achieve less fluctuation in net profits.

Disadvantages of Absorption Costing

Despite the good benefits that companies can derive from using the absorption costing method, it has some disadvantages. The major dark sides of this costing method include the fact that it results in the increase of net income. Because this method accounts for fixed costs, the higher the goods produced at a time, the lesser the fixed costs that will be attributable to the production of the goods, which in turn causes the net income to increase. Hence, the fixed costs accounted for in this method is less favorable compared to variable costing. Another disadvantage of absorption costing is that cost volume profit (CVP) is difficult to analyze when it is being used.

Related Topics

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 costingAbsorption costing is one of approach which is used for the purpose of valuation of inventory or calculation of the cost of the product in the company where all the expenses incurred by the company are taken into the consideration i.e., it includes all the direct and indirect expenses incurred by the company during the specific period.read more includes all costs associated with a production process assigned to the units produced.

You are free to use this image on your website, templates, etc., Please provide us with an attribution link

Source: Variable Costing vs Absorption Costing (wallstreetmojo.com)

Variable costing consists of direct material costs, direct labor costs, and variable manufacturing overheadsManufacturing Overhead is the total of all the indirect costs involved in manufacturing a product like Property Tax on the production premise, Remunerations of maintenance personnel, Rent of the manufacturing building, etc. read more, 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 ratePredetermined overhead rate is the distribution of expected manufacturing cost to the presumed units of machine-hours, direct labour hours, direct material, etc., for acquiring the per-unit expense before every accounting period.read more based on normal capacity.

You are free to use this image on your website, templates, etc., Please provide us with an attribution link

Source: Variable Costing vs Absorption Costing (wallstreetmojo.com)

Key Differences

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 overheadFactory Overhead, also called Factory Burden, is the total of all the indirect expenses related to the production of goods such as Quality Assurance Salaries, Factory Rent, & Factory Building Insurance etc. read more. 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 decisionsA Make or Buy Decision is a decision to either manufacture a product/ service in house or buy it from outside suppliers (outsourcing) based on cost-benefit analysis. A planned decision can be made using quantitative or qualitative research.read more, 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 productThe contribution margin is a metric that shows how much a company's net sales contribute to fixed expenses and net profit after covering the variable expenses. As a result, we deduct the total variable expenses from the net sales when computing the contribution.read more. 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 accountingAccounting methods define the set of rules and procedure that an organization must adhere to while recording the business revenue and expenditure. Cash accounting and accrual accounting are the two significant accounting methods.read more. 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 principleThe Matching Principle of Accounting provides accounting guidance, stating that all expenses should be recognized in the income statement of the period in which the revenue related to that expense is earned. This means that, regardless of when the actual transaction is made, the expenses that are entered into the debit side of the accounts should have a corresponding credit entry in the same period.read more 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 costsOverhead cost are those cost that is not related directly on the production activity and are therefore considered as indirect costs that have to be paid even if there is no production. Examples include rent payable, utilities payable, insurance payable, salaries payable to office staff, office supplies, etc.read more 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.

Variable vs Absorption Costing Comparative Table

Conclusion

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.