Explain the difference between variable and absorption costing. How unit product cost is computed under two methods?

Variable and absorption are two different costing methods. Almost all successful companies in the world use both the methods. Variable costing and absorption costing cannot be substituted for one another because both the systems have their own benefits and limitations.

These costing approaches are known by various names. 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.

The information provided by variable costing method is mostly used by internal management for decision making purposes. Absorption costing provides information that is used by internal management as well as by external parties like creditors, government agencies and auditors etc.

Computation of unit product cost under two methods:

Under absorption costing system, the product cost consists of all variable as well as all fixed manufacturing costs i.e., direct materials, direct labor and factory overhead (FOH). But when variable costing system is used, the fixed cost (both manufacturing and non-manufacturing) is treated as a period or capacity cost and therefor is not included in the product cost.

Following exhibition summarizes the difference between variable costing and absorption costing:

Variable versus absorption costing

Variable Versus Absorption Costing

For further clarification of the concept, consider the following examples:

Example 1

A company manufactures and sells 5000 units of product X per year . Suppose one unit of product X requires the following costs:

Direct materials: $5 per unit
Direct labor: $4 per unit
Variable manufacturing overhead: $1 per unit
Fixed manufacturing overhead: $20,000 per year

The unit product cost of the company is computed as follows:

Absorption Costing Variable Costing
$5 $5
$4 $4
$1 $1
$4* -
——- ——-
$14 $10
——- ——-

* $20,000 / 5,000

Notice that the fixed manufacturing overhead cost has not been included in the unit cost under variable costing system but it has been included in the unit cost under absorption costing system. This is the primary difference between variable and absorption costing.

Example 2

Sunshine company produces and sells only washing machines. The company uses variable costing for internal reporting and absorption costing for external reporting. The data  for the year 2010 is given below:

Direct materials $150/unit
Direct labor $45/unit
variable manufacturing overhead $25/unit
Fixed manufacturing overhead $160,000 per year
Fixed marketing and administrative expenses $110,000 per year
Variable marketing and administrative expenses $15/unit sold

Company produced and sold 8,000 machines during the year 2010.

Required: Compute unite product cost under variable costing and absorption costing.

Solution

Absorption Costing Variable Costing
Materials $150 $150
Labor $45 $45
Variable overhead $25 $25
Fixed overhead $20*
——- ——-
240 220
——- ——-

*$160,000 / 8,000 Units = $20

Note: Marketing and administrative expenses are not relevant here.