Variable costing versus absorption costing

By: Rashid Javed | Updated on: January 8th, 2017

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 is, therefore, 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: $5 + $4 + $1 + $4* = $14

Variable Costing: $5 + $4 + $1 = $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.

A D V E R T I S E M E N T

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 2016 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 2016.

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

Solution:

variable-vs-absorption-costing-img1

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

Note: Marketing and administrative expenses are period costs and are not relevant in the computation of unit product cost.

More from Variable and absorption costing (explanations):
A D V E R T I S E M E N T
54 Comments on Variable costing versus absorption costing
  1. How about when the unit production and unit sold are different? which one we have to choose to calculate the unit product cost?

  2. can you help me to solve this problem
    ) Durante Company reported the following information about the production and sale of its only product during the first month of operations:

    Selling price per unit $300
    Sales $480,000
    Direct materials used $220,000
    Direct labor $200,000
    Variable factory overhead $60,000
    Fixed factory overhead $80,000
    Variable selling and administrative expenses $20,000
    Fixed selling and administrative expenses $10,000
    Ending inventory, Direct Materials 0
    Ending inventory, Work-in-process 0
    Ending inventory, Finished Goods 400 units

    Under variable costing, the cost of finished goods ending inventory is ________.

  3. Accounting For Management

    Total units manufactured during the month:
    Units sold + units in ending inventory
    1,600* + 400
    = 2,000

    *480,000/300

    Variable manufacturing cost:
    Direct materials used + Direct labor + Variable factory overhead
    220,000 + 200,000 + 60,000
    = 480,000

    Variable manufacturing cost per unit:
    $480,000/2,000 = $240

    Cost of finished goods ending inventory:

    400units*$240 = $96,000

  4. How if the budgeted production is 40 000 and the actual production is 50 000. Which one will be use to determine the fix production overhead per unit? is it 300 000/50 000 or 300 000/40 000?

  5. Can you please explains:
    why absorption includes fixed costs?
    Explains effect of ending inventory on operating income?
    Clear on results of Production more than sales, sales more than production and sales equals production

  6. Sajjad Badar becaus admin& selling expenses is period costs not product costs, don,t forget we interest about product cost only that,s mean we compute manofactory expenses to detemine units cost not admin& selling expenses

  7. I would like to be assisted with the following question:

    1. The following budgeted information relates to a manufacturing company for next period:

    production 14 000 sales 12000 units and fixed production costs R63000 and fixed selling costs R12000.
    the normal level of activity is 14000 units per period.
    using an absorption costing, the profit for the next period has been calculated as R36000.
    what would be the profit for the next period using marginal costing.

  8. Accounting For Management

    As the inventory is increasing, the profit under absorption costing would be higher than the marginal costing.

    Begining inventory: 0 units
    Ending inventory: 14,000 – 12,000 = 2,000 units
    Per unit fixed manufacturing cost: 63,000/14,000 = R4.5
    Total cost of ending inventory: 2,000*4.5 = R9,000
    Profit for the next period under marginal costing: R36,000 – R9,000 = R27,000

  9. Hello,

    Is that inventory and COGS under absorption costing are always higher than variable costing? If not, which one is correct statement? And how about fixed overhead expenses? Under which method has always higher fixed overhead expenses?

    Thanks

  10. As much as this is useful,

    Can we conclude that in the long run, total costs incurred will be the same under a FIFO method?

    I know that using one or the other can maximize net income but my question has to do with the long term nature of the cost.

    If anyone can answer this it would be unreal!!

    Thanks

  11. please help me solve this
    Bindu Ltd is a manufacturing company and has provided you with the following information for the two years ende 30 June 2002 and 30 June 2003

    2002 units 2003 units
    sales 4200 4400
    production 4500 4800
    fixed cost
    manufacturing 36000 43200
    unit data selling price 47 51
    direct material 10 12
    direct labour 15 18
    variable prodution overhead 7 9
    admin and marketing 11400 13680

    there was no opening stock of finished goods in the ear ended 30 June
    Stocks are valued on a FIFO basis
    Required to calculate the closing stocks for each year using the absoption costing method and marginal costing method and the profit statements

  12. Pls help…
    A Business manufacture plastic bags at the begining of the year there were 1000units.During the year 10,000units bags were produced & following cost was incured….
    labour:-
    skilled -2 (25) /unit
    unskilled – 2 (30) /unit
    Materials:-
    A – 5 (20) / unit
    B – 3 (25) / unit
    Direct cost – 40/unit
    Fixed cost – 1,000,00
    Pls help to solve this
    (i need both Absorption & Marginal(variable) costing
    Help as Possiable

  13. Hi experts Can u please please …. help me slove cost account problem
    Big Ben company established new manufacturing unit of casual gents shirts: each shirt company sell at US$ 48 each, it coat variable cost to make 1 shirt US$ 21 each (such as materials, accessories, labor, ect), and cost US$ 68,000 per month fixed cost to run the factory (such as, salaries, rent, fixed overheard, ect). And company most like sell 3000 peace of shirts per month.

    What is the gross margin per shirt
    What is the total gross margin for shirts sold during the month

  14. Hi can you help me solve this problem.? Prepare income statement under 1) absorption costing 2) marginal cisting
    A clothing company has the following data which produced and sold T-shirts. Opening inventories if 500 T-shirts valued @$ 100,000 including variable cost of $80 per tshirt
    Production. 5000 units
    Sales at $300 per T-shirt. 400units
    Direct material cost. $200,000
    Direct labor cost. $100,000
    Factory overhead
    Variable cost. $100,000
    Fixed costs. $600,000
    Selling and distribution overheads
    Variable cost. $20,000
    Fixed cost. $30,000
    Closing inventories is valued at current cist

  15. why didn’t we compute v. Selling & admin. Costs in product cost under variable costing method ?
    Don’t V. S&A costs change with production level so, we should have calculated them ? Or we only use it to determine contribution margin not product cost ?

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