This includes direct and indirect costs, such as materials, labor, overheads, and marketing. The purpose of absorption costing is to create a full-cost accounting system that can be used to make pricing decisions. Under variable costing, the fixed overhead is not considered a product cost and would not be assigned to ending inventory.

The other main difference is that only the absorption method is in accordance with GAAP. In case the procurement price is lower than the marginal cost of production, it will be advisable to procure the product from outside rather than manufacture it in the factory. However, most companies have units of product in inventory at the end of the reporting period. For example, if you know that your company’s rent will increase next year, you can use the period cost per day to estimate how much this will increase your monthly expenses.

Understanding Absorption Costing

For example, if the total variable cost is $100 and 100 units are produced, the variable cost per unit would be $1. Management requires knowledge of cost behaviour under various operating conditions and business decisions. Variable overhead includes costs such as electricity and supplies that vary with production volume. Fixed overhead includes costs such as rent and property taxes that do not vary with production volume.

Customer profitability analysis is an application of segmented reporting in which a customer group is treated as a segment. This analysis may be done using variable costing to determine a customer contribution margin or absorption costing to determine a customer gross margin based on full-cost cost of sales. It is especially helpful when combined with an activity-based costing approach that determines which activities are performed for each group and assigns costs based on appropriate drivers.

Arguments for Variable Costing in Managerial Decision Making

Absorption costing “absorbs” all of the costs used in manufacturing and includes fixed manufacturing overhead as product costs. Absorption costing is in accordance with GAAP, because the product cost includes fixed overhead. Variable costing considers the variable overhead costs and does not consider fixed overhead as part of a product’s cost. It is not in accordance https://turbo-tax.org/where-does-your-tax-money-go/ with GAAP, because fixed overhead is treated as a period cost and is not included in the cost of the product. For internal accounting purposes, both can also be used to value work in progress and finished inventory. The overall difference between absorption costing and variable costing concerns how each accounts for fixed manufacturing overhead costs.

Advocates of absorption costing argue that fixed manufacturing overhead costs are essential to the production process and are an actual cost of the product. They further argue that costs should be categorized by function rather than by behavior, and these costs must be included as a product cost regardless of whether the cost is fixed or variable. Under the absorption costing method, all costs of production, whether fixed or variable, are considered product costs.

Limitations of Variable Costing – GAAP

Fixed production costs may not be con­trollable at departmental level and therefore should not be included in the production costs at costs centre level, as it is important to match control with responsibility. Companies that use variable costing experience fewer cost changes from inventory adjustments. For example, changes in product cost, selling price or the company’s sales mix will not affect the profit for a single accounting period. Companies can expect smoother profit reporting throughout multiple accounting periods, making forecasting costs from production increases easier. Even if a company must use absorption costing

for its external reports, a manager can use variable costing statements

for internal reports.

At any rate, absorption costing is the generally accepted method for preparing

mandatory external financial reporting and income tax returns. 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. It does not include a portion of fixed overhead costs that remains in inventory and is not expensed, as in absorption costing. Given the limitations of absorption costing, you might wonder if there are other methods of costing and pricing that you can use. One of them is variable costing, which only allocates the variable costs of production to the units of output and treats the fixed costs as period costs.

Advantage: Unaffected by Inventory Changes

Using the absorption costing method on the income statement does not easily provide data for cost-volume-profit (CVP) computations. In the previous example, the fixed overhead cost per unit is \(\$1.20\) based on an activity of \(10,000\) units. If the company estimated \(12,000\) units, the fixed overhead cost per unit would decrease to \(\$1\) per unit. While companies use absorption costing for their financial statements, many also use variable costing for decision-making. The Big Three auto companies made decisions based on absorption costing, and the result was the manufacturing of more vehicles than the market demanded. With absorption costing, the fixed overhead costs, such as marketing, were allocated to inventory, and the larger the inventory, the lower was the unit cost of that overhead.

Depending on a company’s business model and reporting requirements, it may be beneficial to use the variable costing method, or at least calculate it in dashboard reporting. Managers should be aware that both absorption costing and variable costing are options when reviewing their company’s COGS cost accounting process. Using the absorption costing method will increase COGS and thus decrease gross profit per unit produced. Furthermore, it means that companies will likely show a lower gross profit margin. Absorption vs. variable costing will only be a factor for companies that expense costs of goods sold (COGS) on their income statement. Although any company can use both methods for different reasons, public companies are required to use absorption costing due to their GAAP accounting obligations.

Sometimes variable costing may be unnecessarily given a broader significance than it deserves. For instance, when sales are higher than production, variable costing net income will be more than absorption costing net income. In this case, sometimes, management may take unwise actions due to ‘increased profits’ reported by variable costing.

Cost accounting is an essential tool for managers, as it provides information that can be used to make decisions about how to allocate resources and run operations. Since the variable cost is less than the $14 offered to ABC International, it should accept the special order, as this will result in a contribution of $0.20 per mobile phone. Production of such products can be discontinued while production of those products which are more profitable can be taken up.