When it comes to accounting, there are many different methods that businesses can use to track their expenses and revenue. Two commonly used methods are absorption costing and variable costing. Both methods have their advantages and disadvantages, and understanding the difference between them is important for any business owner or manager.
Absorption Costing:
Absorption costing, also known as full costing, is a method of accounting that allocates all manufacturing costs, both variable and fixed, to the cost of goods sold. This means that both direct and indirect costs, such as rent, salaries, and utilities, are included in the cost of goods sold.
Under absorption costing, the cost of goods sold is calculated by adding together the direct materials, direct labor, and manufacturing overhead costs. This method is commonly used for financial reporting purposes, as it provides a more complete picture of the total cost of production.
Variable Costing:
Variable costing, also known as direct costing, is a method of accounting that only allocates variable manufacturing costs to the cost of goods sold. This means that only direct costs, such as direct materials and direct labor, are included in the cost of goods sold. Indirect costs, such as rent and salaries, are treated as period expenses and are not included in the cost of goods sold.
Under variable costing, the cost of goods sold is calculated by adding together only the direct materials and direct labor costs. This method is commonly used for internal decision-making purposes, as it provides a more accurate picture of the incremental costs of production.
Key Differences:
The main difference between absorption costing and variable costing is in how they treat fixed manufacturing costs. Absorption costing includes both fixed and variable costs in the cost of goods sold, while variable costing only includes variable costs. This means that absorption costing results in a higher cost of goods sold and a lower gross profit margin compared to variable costing.
Another difference between the two methods is in how they handle changes in production volume. Under absorption costing, fixed manufacturing costs are spread out over a larger number of units as production volume increases, resulting in a lower per-unit cost. In contrast, under variable costing, fixed costs remain constant regardless of production volume, resulting in a higher per-unit cost as production volume decreases.
Which Method is Best?
The choice between absorption costing and variable costing depends on the needs of the business. Absorption costing is generally preferred for financial reporting purposes, as it provides a more complete picture of the total cost of production. On the other hand, variable costing is more useful for internal decision-making, as it provides a more accurate picture of the incremental costs of production.