Absorption costing is a method in which cost of units produced is calculated as the sum of both the variable manufacturing costs incurred and the fixed manufacturing costs allocated to those units. It is also called full absorption costing or full costing, because all product costs (including the fixed manufacturing overheads) are included in the cost of units produced and carried forward to future periods, instead of being charged wholly to income statement in a single period.
While direct costs (such as direct materials, direct labor and variable manufacturing overheads) are traceable to different units, indirect costs such as fixed manufacturing overheads require allocation to different units on some reasonable basis. Depending on whether fixed manufacturing costs are assigned to units or not, there are two possible approaches to finding cost of units produced, namely absorption costing and variable costing (also called marginal costing). In absorption costing, fixed manufacturing costs are assigned to units while in variable costing (also called marginal costing), fixed manufacturing costs are not assigned to units but are subtracted from sales in the period in which they are incurred.
Absorption costing income statement
Net income under absorption costing can be reconciled with net income under variable costing by (a) subtracting the manufacturing overheads carried forward (absorbed by closing inventories) and (b) adding the manufacturing overheads brought in (absorbed by opening inventories).
Absorption costing and variable costing are methods used to value companies' work in progress and inventory, for accounting purposes. Absorption costing includes all the costs associated with the manufacturing of a product. Variable costing includes the variable costs directly incurred in production and none of the fixed costs. For reporting purposes, absorption costing is required under the Financial Accounting Standards Board’s Generally Accepted Accounting Principles (GAAP).
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.
Key Takeaways
- Absorption costing includes all of the direct costs associated with manufacturing a product.
- Variable costing can exclude some direct fixed costs.
- Absorption costing entails allocating fixed overhead costs to all units produced for an accounting period.
- Variable costing includes all of the variable direct costs in COGS but excludes direct, fixed overhead costs.
- Variable costing can provide a clearer picture of per-unit cost and inventory value because it excludes the fixed overhead cost.
Direct and Indirect Costs
Before looking at absorption versus variable costing, it's important to understand the difference between direct and indirect costs on the income statement. Direct costs are usually associated with COGS, which affects a company’s gross profit and gross profit margin. Indirect costs are associated with the operating expenses of a company. These costs heavily influence operating profit and the operating profit margin.
Some of the direct costs associated with manufacturing a product include wages for workers physically manufacturing a product, the raw materials used in producing a product, and direct overhead costs involved in manufacturing a product.
Indirect expenses are not directly associated with manufacturing. These can include:
- Research and development
- Some depreciation
- Amortization of intangibles
- Selling expenses
- Marketing expenses
- Administrative expenses
- Other expenses
Absorption Costing
Absorption costing is also known as full costing. Public companies are required to use the absorption costing method in cost accounting management for their COGS. Many private companies also use this method because it is GAAP-compliant whereas variable costing isn't.
Absorption costing involves allocating all of the direct costs associated with manufacturing a product to COGS. This includes any variable costs directly associated with manufacturing, such as:
- Cost of raw materials
- Hourly cost of labor
- Salaries of manufacturing workers
- Variable costs of electricity used to run a plant in manufacturing mode
This also includes any direct fixed costs, such as:
- The mortgage payment on a building used for manufacturing
- Insurance on a manufacturing property
- Depreciation on a manufacturing machine
Depending on a company’s level of transparency, an income statement using absorption costing may break out variable direct costs and fixed direct costs into two line items or combine them together to report a comprehensive COGS. In any case, the variable direct costs and fixed direct costs are subtracted from revenue to arrive at the gross profit.
Using the absorption costing method will increase COGS and thus decrease gross profit per unit produced. This means companies will have a higher breakeven price on production per unit. It also means that customers will pay a slightly higher retail price. Furthermore, it means that companies will likely show a lower gross profit margin.
The impact of absorption costing will depend on the business. For example, a company has to pay its manufacturing property mortgage payments every month regardless of whether it produces 1,000 products or no products at all. A company may see an increase in gross profit after paying off a mortgage or finishing the depreciation schedule on a piece of manufacturing equipment. These are considerations cost accountants must closely manage when using absorption costing.
The absorption costing method is typically the standard for most companies with COGS. It is required for compliance with GAAP. Auditors and financial stakeholders will require it for external reporting. Depending on the type of business structure, small businesses may also be required to use absorption costing for their tax reporting.
A main advantage of absorption costing is that it is GAAP-compliant. That means that's the only method needed if it's what a company prefers to use. If a company prefers the variable costing method for management decision-making purposes, it may also be required to use the absorption costing method for reporting purposes.
Variable Costing
Some companies may choose to use the variable costing method. With variable costing, all of the variable direct costs are included in COGS. The fixed direct costs are allocated to operating expenses rather than COGS. The types of fixed direct costs are the same whether a company uses absorption or variable costing:
- A mortgage payment on a building used for manufacturing
- Insurance on a manufacturing property
- Depreciation on a manufacturing machine
Variable costing will result in a lower breakeven price per unit using COGS. This can make it somewhat more difficult to determine the ideal pricing for a product. Variable costing results in gross profit that will be slightly higher. In turn, that results in a slightly higher gross profit margin compared to absorption costing.
Keep in mind, companies using the cash method may not need to recognize some of their expenses as immediately with variable costing since they are not tied to revenue recognition. This can be an advantage.
The reason variable costing isn't allowed for external reporting is because it doesn't follow the GAAP matching principle. It fails to recognize certain inventory costs in the same period in which revenue is generated by the expenses, like fixed overhead.
Key Differences
Both costing methods can be used by management to make manufacturing decisions. 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.
Here's a summary of their differences.
Absorption Costing Variable CostingMethodApplies all direct costs, fixed overhead, and variable manufacturing overhead to the cost of a productOnly variable costs are applied to the cost of a product; fixed overhead costs are expensed in the period in which they occurUseCalculates a per-unit cost of fixed overheadDetermines a lump-sum for fixed overhead costsInventoryInventory value includes direct material, direct labor, and all overheadInventory value does not include fixed overheadAccountingCan cloud picture of company profitability for an accounting period because all fixed costs are not deducted from revenues (unless all inventory is sold)Doesn't match expenses to revenue (with regard to inventory) in the same accounting period; may result in a more realistic inventory value and actual profit since unsold stock doesn't absorb fixed overhead costsReportingAcceptable costing method under GAAPNot an acceptable costing method under GAAP
Absorption Costing vs. Variable Costing Example
Let's say that ABC company manufactures and sells 20,000 units of its product yearly. A single product includes these costs:
- Direct materials: $3 per unit
- Direct labor: $5 per unit
- Variable manufacturing overhead: $2 per unit
- Fixed manufacturing overhead: $35,000 per year, which computes to a $1.75 per unit cost ($35,000/20,000 annual units)
Under the absorption costing method, the per unit cost of product would be:
$3 + $5 + $2 + $1.75 = $11.75
Under the variable costing method, the per unit cost of product would be:
$3 + $5 + $2 = $10
Is Variable Costing More Useful Than Absorption Costing?
It can be, especially for management decision-making concerning break-even analysis to derive the number of product units needed to be sold to reach profitability.
What Are the Advantages of Variable Costing?
Unlike absorption costing, variable costing doesn't add fixed overhead costs into the price of a product and therefore can give a clearer picture of costs. By assigning these fixed costs to cost of production as absorption costing does, they're hidden in inventory and don't appear on the income statement.
What Are the Disadvantages of Variable Costing?
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).
The Bottom Line
Most companies will use the absorption costing method if they have COGS. What's more, for external reporting purposes, it may be required because it's the only method that complies with GAAP. Companies may decide that absorption costing alone is more efficient to use.
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.
If a company has high direct, fixed overhead costs it can make a big impact on the per unit price. Companies that use variable costing may be able to allocate high monthly direct, fixed costs to operating expenses. This could result in a more reasonable per unit price in some cases. However, most companies may need to transition to absorption costing at some point, which can be important to factor into short-term and long-term decision making.