Absorption and Variable Costing

Assignment 8.1

Gerardo R. Cabrera Molina

Managerial Accounting

Polytechnic University of Puerto Rico

 8–1. Briefly explain the difference between absorption costing and variable
costing.

Absorption costing is a method of ‘inventory costing’ in which the total costs viz.,
fixed manufacturing costs as well as variable manufacturing costs, both are included a
inventoried costs, both are included as inventoried costs. Under this costing, fixed
overhead is applied to manufactured goods as a product cost. The fixed overhead cost
remains in inventory until the goods are sold.

On the other hand, variable costing, also known as ‘direct costing’ is a method of
inventory in which only all variable costs are included as inventoried costs, all fixed costs
are excluded and treated as period costs, i.e., the costs of the period in which they are
incurred. If may be noted that both these methods i.e., Absorption costing and variable
costing are the methods used for costing the inventories in manufacturing companies.
The basic difference between these two methods is none of conceptual in nature i.e.,

Whether fixed costs, both, direct and indirect are inventoried costs are inventoried
costs. Because under both the methods, the non-manufacturing costs such as research
and development, marketing etc. whether fixed or variable, are recorded as expenses
when incurred. The only discrimination is about the “fixed manufacturing costs”, with
‘timing’ being the key factor for the difference. The differences between the absorption
costing and the variable costing are presented in the following table.

Summarizing:

Absorption Costing

1. Al costs, both fixed and variable costs are included

2. Unit costs differ at different levels of output, because fixed expenses remain the
same.
3. Costs are classified according to the function, production cost, selling and
distribution costs.
4. Profit is the difference between sales and total costs.
5. Relationship between costs, volume and profits cannot be established.
6. The opening and closing inventories of work-in-progress include a part of the
fixed costs, which are actually period costs.
 7. Fixed costs are charged at predetermined rate and hence the possibility of over
or under application.
8. Not very useful in make-or-buy accept or reject an order, decision or minimum
price fixation during depression etc.

Variable Costing

1. Only variable costs are included fixed costs are recovered from the “Contribution”
2. Variable cost per unit remains the same at different levels of output, because
variable costs vary in the same proportion in which output varies.
3. Costs are classified according to the behavior of costs, fixed and variable costs.
4. Difference between sales and variable costs is the contribution towards fixed
costs and the difference between the contribution and fixed costs is either profit
or loss.
5. Cost, volume, profit (CVP) relationship is an integral part of variable costing.
6. The work-in-progress includes only variable costs and fixed costs are charged to
that period only in which they are included.
7. No over or under application of fixed overheads, because only variable costs
remain constant.
8–2. Timing is the key in distinguishing between absorption and variable costing.
Explain this statement.

Definitely, I have to agree. Timing is an important basis for distinguishing between

absorption costing and variable costing. The discrepancies between absorption-costing
and variable costing income occur because of the changes and differences in inventory
levels during the particular period. That is why it is common for production and sales to
differ over the course of a week. Under both the product costing system, the fixed over-
heads are attached to the products. However, under variable costing, they are expenses
immediately, as they are incurred. On the other hand, under absorption costing, fixed
overheads are inventories until the accounting period during which the manufactured
goods are sold. Part of the fixed costs is carried forward to the next period because the
closing stock of work in process and finished goods is valued at cost of production which
is inclusive of fixed costs. The fixed costs are period costs and should be charged to the
period in which they are incurred and not be carried over to the next period. This is done
under variable costing and not in absorption costing.
Reference:

Hilton, R. (2010). Managerial Accounting: Creating Value in a Dynamic Business

Environment, 8th ed. McGraw Hill Irwin (chapter 8).