6 4: Compare and Contrast Traditional and Activity-Based Costing Systems Business LibreTexts

In conclusion, absorption costing and variable costing are two distinct methods of cost allocation that differ in their treatment of fixed manufacturing overhead costs. Absorption costing includes fixed manufacturing overhead costs in the cost of each unit produced and values inventory at a higher level. On the other hand, variable costing treats fixed manufacturing overhead costs as period expenses and only includes variable manufacturing costs in the cost of each unit produced. The choice between absorption costing and variable costing depends on the nature of the business, the stability of inventory levels, and the desired level of cost control and decision-making accuracy. The choice between absorption costing and variable costing can also have implications for profitability analysis.

Absorbing Costs through Overproduction

The classic example of and industry using this type of absorption are gold jewelers the typical absorption rate varies from 2-5% of the cost of the gold. If in the same industry material of different cost is used the calculation becomes unjustified, especially when the cost of the material differ too much. It also disregards the administrative cost when calculating the unit cost so that any cost incurred during the period. Absorption costing is also not effective or helpful in the comparison of product lines. This is comprised of a standard set of accounts that are always included in cost pools, and which should rarely be changed. These include white papers, government data, original reporting, and interviews with industry experts.

Margin Size

To calculate COGS, add the cost of products produced for the time to the dollar worth of initial inventory. While it’s a valuable management tool, it isn’t GAAP-compliant and can’t be used for external reporting by public companies. Therefore, if a company uses variable costing, it may also have to use absorption costing (which is GAAP-compliant).

Explore the finer points of the absorption costing formula, including the pros and cons of absorption costing and how to work out absorption costing. With absorption costing, even overhead costs that are unable to be directly traced back to the product are assigned to each unit. Managers can make decisions to improve their profitability by understanding both types of costs. In management accounting, period costs are incurred in a specific period and can be directly linked to the revenues or activities of that period. For example, the salaries of employees who worked in a given month are period costs, as are the costs of materials used to produce products in that month.

This choice impacts everything from pricing strategies to understanding the true cost of production, which in turn affects your business’s financial health and competitive position in the market. Variable costing also supports break-even analysis and contribution margin calculations. The contribution margin, calculated as sales revenue minus variable costs, highlights the revenue available to cover fixed costs and generate profit.

• Based on absorption costing methods, the additional unit appears to produce a loss of $0.50, and it appears that the correct decision is to not make the sale.
• The Big Three auto companies made decisions based on absorption costing, and the result was the manufacturing of more vehicles than the market demanded.
• This approach can be helpful when making short-term decisions, such as whether to continue producing a product or how to price it.

Cost Accounting for Ethical Business Managers

Under variable costing, the company may find that its sleek, modern chairs are not as profitable as previously thought when fixed manufacturing overhead is excluded from the cost per unit. This insight could lead to strategic changes such as price adjustments, cost reduction initiatives, or even discontinuing the product line. Under variable costing, if the variable cost per widget is $5 and the selling price is $10, the contribution margin is $5 per widget.

This can provide a clearer picture of the profitability of a company’s operations, especially when inventory levels fluctuate significantly. Since no portion of fixed manufacturing overhead is absorbed by the ending inventory under variable costing, the question of deferral or release of fixed cost does arise under this costing approach. In contrast, absorption costing, sometimes referred to as full costing, allocates all manufacturing costs to the product, whether they are variable or fixed.

Figure 8.1.1 shows the cost to produce the 10,000 units using absorption and variable costing. General or common overhead costs like rent, heating, electricity are incurred as a whole item by the company are called Fixed Manufacturing Overhead. Using units produced will allow overhead to be allocated to all of the units, those that were sold and those that are still remaining in inventory. Since fixed costs are distributed among every product manufactured, the fixed costs of every unit will lessen with every item that is further produced.

The difference is that the absorption cost method includes fixed overhead as part of the cost of goods sold, while the variable cost method includes it as an administrative cost, as shown in (Figure). The difference is that the absorption cost method includes fixed overhead as part of the cost of goods sold, while the variable cost method includes it as an administrative cost, as shown in Figure 6.12. Understanding these costing methods is crucial for managers making pricing and production decisions. The choice between variable and absorption costing can significantly affect financial reporting, break-even analysis, and performance evaluation in manufacturing companies.

Under absorption costing, direct materials, direct labor, and overhead are all included in the cost of a product. Variable costing and absorption costing are two different costing approaches that companies use for assigning cost to products, valuing inventories, and computing the cost of goods sold (COGS). For example, variable costing is also known as direct costing or marginal costing, and absorption costing is also known as full costing or traditional costing. As a general rule, relate the difference in netincome under absorption costing and variable costing to the changein inventories. Conversely, ifinventories decreased, then sales exceeded production, and incomebefore income taxes is larger under variable costing than underabsorption costing.

This approach results in a more conservative balance sheet, offering stakeholders a clearer view of operational cash flow. Lower inventory values can influence liquidity ratios differently, potentially presenting a less liquid position. Managers often rely on this insight for internal assessments, focusing on efficiency and cost control without the influence of fixed cost allocation. By understanding how product and period costs impact profitability, management can make better strategic decisions about pricing, production levels, and other aspects of their business.

Example 3 – computation of cost of goods sold and ending inventory figures

• By making informed decisions based on data-driven analysis, management can improve the profitability of their business and create long-term value for their shareholders.
• Absorption costing includes fixed overhead as part of the inventory cost, and it is expensed as cost of goods sold when inventory is sold.
• Variable costing, on the other hand, is a more accurate reflection of the true costs of production.
• Production is estimated to hold steady at \(5,000\) units per year, while sales estimates are projected to be \(5,000\) units in year \(1\); \(4,000\) units in year \(2\); and \(6,000\) in year \(3\).
• The differences in expense recognition between variable and absorption costing can significantly affect financial outcomes and managerial strategies.
• Direct costing assigns the direct costs of producing a good or service to that product, while absorption costing assigns all production costs, including indirect costs, to a product.

Each method offers a different perspective on cost allocation and can significantly impact a company’s financial statements and tax liabilities. Variable costing, also known as direct costing or marginal costing, includes only variable production costs—costs that change with the level of output, such as raw materials and direct labor. Fixed overhead costs, like factory rent and salaries of permanent staff, are not allocated to product costs under this method. Instead, they are treated as period costs and are expensed in full during the period they are incurred. For example, assume a new company has fixed overhead of $12,000 and manufactures 10,000 units. Direct materials cost is $3 per unit, direct labor is $15 per unit, and the variable manufacturing overhead is $7 per unit.

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

The strategic decision between variable and absorption costing is not one to be taken lightly. It requires a careful consideration of the company’s operational, financial, and strategic objectives. The choice ultimately hinges on the specific context and priorities of the business, making it a critical strategic decision in cost management.

This means that fixed costs, such as rent and salaries, are allocated to each unit produced. On the other hand, variable costing only includes the variable costs, such as direct materials and direct labor, in the cost of a 6 5 compare and contrast variable and absorption costing product. Absorption costing provides a more accurate reflection of the total cost of production, while variable costing allows for better analysis of the contribution margin and helps in decision-making processes. Variable costing only includes the product costs that vary with output, which typically include direct material, direct labor, and variable manufacturing overhead. Fixed manufacturing overhead is still expensed on the income statement, but it is treated as a period cost charged against revenue for each period.

Advantages and Disadvantages of the Absorption Costing Method

However, variable costing may be the more straightforward method if you’re selling at a profit. Using the cost per unit that we calculated previously, we can calculate the cost of goods sold by multiplying the cost per unit by the number of units sold. Overall, this statement is much easier to make if you understand product and period costs. Calculate the unit cost first, as that is the most difficult portion of the statement. Net income on the two reports can be differentif units produced do not equal units sold. The choice between variable and absorption costing should be made with a clear understanding of your business’s specific needs, the nature of your costs, and your strategic objectives.