Absorption Costing vs. Variable Costing: What's the Difference?

Absorption and variable costing are the two most common accounting approaches for valuing a company's work in progress and inventory. Absorption costing includes all expenses related to the production of a product. Only the constantly changing costs directly incurred in production are included in variable costing, and all fixed costs are excluded.

Companies that showcase COGS (cost of goods sold) on their income statements must choose between absorption and variable costs. Although either approach can be employed for various reasons, GAAP (Generally Accepted Accounting Principles) suggests or forces public firms to utilize absorption costing. COGS are typically associated with direct costs, affecting a company's gross profit margin.

What is Absorption Costing?

Full costing is another name for absorption costing. Public firms must apply the absorption costing approach in cost accounting management for their COGS. This method is also used by many private companies because it is GAAP-compliant, whereas variable costing is not.

Absorption costing is allocating all direct costs associated with the manufacture of a product to COGS. This also includes any variable costs that are directly related to manufacturing, such as:

• Raw material costs
• Labor cost per hour
• Manufacturing worker salaries
• Monthly electricity costs for running a manufacturing plant

This includes any direct fixed costs as well, such as:

• The mortgage payment on a manufacturing facility
• Insurance for a manufacturing facility
• A manufacturing machine's depreciation

The absorption costing method increases the cost of goods sold while decreasing the gross profit per unit produced. This means that companies' breakeven point for production per unit will be higher. As a result, customers will pay a little higher retail price. Furthermore, it implies that companies' gross profit margins will likely be lower.

Now take an example, whether a company produces 1,000 products or none, it must make monthly mortgage payments on its manufacturing property. A company's gross profit may grow after paying off a mortgage or finishing the depreciation schedule on a piece of industrial equipment. When employing absorption costing, cost accountants must keep these things in mind.

Most companies with COGS employ the absorption costing method, which is required for GAAP compliance and will be needed for auditors and financial stakeholders to report on externally.

What is Variable Costing?

All variable direct expenses are included in COGS when incorporating variable costing. The fixed direct costs are attributed to operating expenditures rather than COGS. However, the forms of fixed direct costs are the same whether a corporation utilizes absorption or variable costing. Such fixed direct costs may include the following::

• A manufacturing facility's mortgage payment
• Manufacturing facility insurance
• Depreciation of a manufacturing machine

Variable costs in conjunction with COGS result in a reduced breakeven price per unit. This sometimes makes it more difficult to choose the optimal pricing for a product. Variable costing produces a marginally higher gross profit. As a result, the gross profit margin is often higher than that of absorption costing. Since the cash method is not linked to revenue recognition, businesses may only need to gradually recognize some of their expenses with variable costing.

What are some important distinctions between absorption costing and variable costing?

Management can make manufacturing decisions using either costing method. Here's a breakdown of the differences between both costing methods:

What are the points to consider before selecting a method?

The costing method is determined by factors such as the accounting purpose and the type of company. Here are some pointers to consider or follow when deciding between absorption and variable costing:

Consult a Manager or a Co-worker

Discussing the situation with a manager or colleague is a good idea before deciding on a costing method. Discussing why a company wants to calculate COGS can help you determine its key goals and objectives, which can help you determine which way to go in order to benefit the company. For example, the absorption costing method may be preferable if the company intends to provide important information to investors. If the company wants to know whether it should increase the price of its products, the variable method may be more useful.

Understand the Rules and Regulations

Knowing the rules and regulations is essential because it will help you decide which accounting method to use. Examine the GAAP and IFRS (International Financial Reporting Standards) regulations to ensure that the company can adhere to them before deciding which costing calculation to perform. To comply with GAAP accounting standards, public companies, for example, must use absorption costing. If one needs more clarification, he must talk to the company's legal team or another accounting professional.

Learn to Read Each Calculation

Each costing calculation has a different impact on a company's financial health. A thorough understanding of each calculation can assist businesses in determining whether or not critical financial adjustments are required. For example, because the absorption costing method only deducts fixed costs from revenue once the company sells the products, the absorption method may not provide companies with their actual expenses, which can affect their financial and manufacturing decisions. A company can create a more realistic product price using the variable costing method. Still, it may need to know the total price of the company's fixed costs to know if the selling price is too low.

Regulations

The GAAP (Generally Accepted Accounting Principles) and the IFRS (International Financial Reporting Standards) establish the major rules and regulations businesses must follow for their accounting and finance activities, including the generation of financial reports. The GAAP and IFRS often require companies to use the absorption costing method when creating financial statements to ensure they provide the government with the total cost value of their inventory and goods sold.

Because of the matching principle, the GAAP and IFRS do not typically accept the variable costing method when companies create official financial reports. According to the matching principle, businesses must report expenses in the same period that they generate revenue. Companies must also disclose all costs associated with their manufacturing systems. Because it only lists some of the company's expenses, the variable costing method falls short of those expectations.

Is variable costing better than absorption costing?

It can be a better choice, especially for management decision-making regarding breakeven analysis to determine the number of product units required to achieve profitability. However, it is always recommended to talk with professionals before selecting the right costing approach.

What are the drawbacks of variable costing?

While variable costing is a useful management tool, it is not GAAP-compliant. It cannot be used by public companies for external reporting. As a result, if a company employs variable costing, it may also be required to utilize absorption costing (which is GAAP-compliant).

The Bottom Line

The absorption costing approach will likely be used by a corporation having COGS. Furthermore, it may be required for external reporting because it is the sole GAAP-compliant approach. Businesses may determine that relying only on absorption costs is more efficient. When assessing their company's COGS cost accounting process, managers should be aware that absorption and variable costing are both possibilities.

The per-unit pricing might be dramatically influenced if a corporation has large direct, fixed overhead expenditures. Companies with variable costs might devote a large portion of their monthly direct, fixed expenditures to operational expenses. In certain cases, this may result in a lower per-unit price. However, most businesses will need to transition to absorption costing at some point, which must be included in both short-term and long-term decision-making.