Overview of Variable and Absorption Costing

At least two methods can be used in manufacturing companies to value units of product for accounting purposes - absorption costing and variable costing. These methods differ only in how they treat fixed manufacturing overhead costs.

Variable Costing

Variable costing includes only variable production costs in product costs. Direct materials, direct labor and variable manufacturing overhead costs would ordinarily be included in product costs under variable costing. Fixed manufacturing overhead is not treated as a product cost under this method. Rather, fixed manufacturing overhead is treated as a period cost and is charged against income each period. This costing system is used for the internal purpose. So, variable costing considered the following—

Under variable costing, no fixed overhead is assigned to inventory

Fixed overhead is a period expense which enters the income statement as a line item every period regardless of the number of units sold

Variable costing excludes fixed manufacturing overhead from inventoriable costs.

Absorption Costing

Absorption costing treats all production costs as product costs, regardless of whether they are variable or fixed. Under absorption costing, a portion of fixed manufacturing overhead is allocated to each unit of product. Absorption costing is treated as full cost and this costing system is used for the external purpose. So, variable costing considered the following—

Under absorption costing, fixed overhead is assigned to units of inventory and shows up in the income statement as part of the cost of goods sold (COGS) when the units are sold.

When units are produced and not sold, fixed overhead stays in finished goods inventory

Absorption costing includes fixed manufacturing overhead in inventoriable costs.

Cost Classifications

Cost Classifications—Absorption costing versus Variable Costing

Under absorption costing and variable costing, cost can be classified into two ways,

1. Product cost, and

2. Period cost

The cost categories under this two cost classification in case of absorption costing and variable costing.

Under absorption costing method, all manufacturing costs, variable and fixed, are included when determining the unit product cost. Direct materials, direct labor, variable manufacturing overhead, fixed manufacturing overhead costs are included for determining the product costs under absorption costing, and variable selling and administrative expenses and fixed selling and administration expenses are included for  determining the period costs.