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Home Variable Costing System Variable Costing Versus Absorption Costing System
 
 

Variable Costing Versus Absorption Costing:

Absorption Costing or Full Costing System:

Definition and explanation:

Under absorption costing system, all costs of production (both variable and fixed) are treated as product costs. The unit product cost consists of direct materials, direct labor and both variable and fixed overhead. When absorption costing method is used a portion of fixed manufacturing overhead cost is allocated to each unit of product along with variable manufacturing cost. This approach is also called full costing method because all costs of production are included in the product cost.

Variable/Direct/Marginal Costing System:

Definition and explanation:

Under variable costing system, those costs of production that vary with output are treated as product costs. The unit product costs under variable costing system consists of direct materials, direct labor and variable portion of manufacturing overhead. Fixed manufacturing cost is not treated as a product costs under variable costing. Rather, fixed manufacturing cost is treated as a period cost and, like selling and administrative expenses, it is charged off in its entirety against revenue each period. Consequently the cost of a unit of product in inventory or cost of goods sold under this method does not contain any fixed overhead cost. Variable costing is some time referred to as direct costing or marginal costing.

To complete this summary comparison of absorption and variable costing, we need to consider briefly the handling of selling and administrative expenses. These expenses are never treated as product costs, regardless of the costing method in use. Thus under either absorption or variable costing, both variable and fixed selling and administrative expenses are always treated as period costs and deducted from revenues as incurred.

Difference between variable and absorption costing is illustrated below

Cost classifications - Absorption versus variable costing

Absorption Costing

 

Variable Costing

Product cost

Direct materials
Direct Labor
Variable Manufacturing overhead

Product cost

Fixed manufacturing overhead

Period cost

Period cost

Variable selling and administrative expenses
Fixed selling and administrative expenses

Unit Cost Computation:

To illustrate the calculation of unit product cost under both absorption and variable costing consider the following example:

 Example:

A small company that produces a single product has the following cost structure.

Number of units produced 6,000
Variable costs per unit:
Direct materials $2
Direct labor $4
Variable manufacturing overhead $1
Variable selling and Administrative expenses $3
Fixed costs per year:
Fixed manufacturing overhead $30,000
Fixed selling and administrative expenses $10,000

Required:

  1. Compute the unit product cost under absorption costing method.
  2. Compute the unit product cost under variable/marginal costing method.

Unit product Cost
Absorption Costing Method

Direct materials $2
Direct labor $4
Variable manufacturing overhead $1
 
Total variable production cost $7
Fixed manufacturing overhead ($30,000/6,000 units) $5
 
Unit product cost $12
 

Unit product Cost
Variable Costing Method

Direct materials $2
Direct labor $4
Variable manufacturing overhead $1
 
Unit product cost $7
 

(The $30,000 fixed manufacturing overhead will be charged off in total against income as a period expense along with selling and administrative expenses)

Under the absorption costing, notice that all production costs, variable and fixed, are included when determining the unit product cost. Thus if the company sells a unit of product and absorption costing is being used, then $12 (consisting of $7 variable cost and $5 fixed cost) will be deducted on the income statement as cost of goods sold. Similarly, any unsold units will be carried as inventory on the balance sheet $12 each.

Under variable costing, notice that all variable costs of production are included in product costs. Thus if the company sells a unit of product, only $7 will be deducted as cost of goods sold, and unsold units will be carried in the balance sheet inventory account at only $7.

Relevant Articles:

Variable Costing Versus Absorption Costing System
Income Comparison of Variable and Absorption Costing
Advantages, Disadvantages and Limitations of Variable Costing System
Advantages and Disadvantages of Absorption Costing
Variable Costing and Theory of Constraints
Impact of Just In Time (JIT) Inventory Methods on Variable and Absorption Costing System

 

 
 

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Financial Accounting Topics


  Introduction to Accounting
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  Transactions and Accounting Equation
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  Analysis of Business Transactions
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  Journal, Ledger and Trial Balance
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  Accounting for Bills of Exchange
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  Special Journals
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  Cash Book
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Bank Reconciliation Statement
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  Final Accounts
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  Work Sheet
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  Capital and Revenue Items
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  Valuation of Inventories
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  Accounts of Non-profit Making Organizations
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  Statement of Cash Flows
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  Accounting Ratios Analysis
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  Depreciation, Provisions and Reserves
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  Accounting Dictionary
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  Financial Calculators
 
 
 
Managerial Accounting Topics

  Financial Statements
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  Cost Volume Profit Relationship
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  Variable Costing System
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  Materials and Inventory Cost Control
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  Activity Based Costing System
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  Standard Costing and Variance Analysis
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  Balanced Scorecard
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  Capital Investment Analysis/Capital Budgeting
 
 

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