Friday, 20 January 2012

Absorption vs Variable Costing

Absorption vs Variable Costing Meaning:
In the field of accounting, variable (direct) costing and absorption (full) costing are two different methods of applying production costs to products or services. The difference between the two methods is in the treatment of fixed manufacturing overhead costs. Under the direct costing method, fixed manufacturing overhead costs are expensed during the period in which they are incurred. Under the full costing method, fixed manufacturing overhead costs are expensed when the product is sold.

Direct Costing System:
The direct costing method applies all direct costs as well as variable manufacturing overhead costs to the end product. These costs move with the product through the inventory accounts until the product is sold, at which point they are expensed on the income statement as costs of goods sold. Fixed manufacturing overhead costs are expensed during the period in which they are incurred.

Direct costing is also called
variable costing or marginal costing.

Full Costing Method:
The full costing method applies all direct costs and both fixed and variable manufacturing overhead costs to the end product. All of these costs move with the product through the inventory accounts until the product is sold, at which point they are expensed on the income statement as costs of goods sold.

Full costing is also called absorption costing.


Variable Costing Disadvantages and Advantages:
>>Variable costing may provide a clearer picture of the actual incremental costs associated with a specific product. Essentially, the variable costing method can give producers and those concerned with financial records an accurate representation of what actually goes into the costs of producing.
>>Proponents of variable costing argue that fixed manufacturing overhead costs are incurred regardless of production volume and therefore should not be considered in product-related decision-making. Therefore, variable costing method users can enjoy a reported cost that is representative of the actual inputs to the products.
>>However, by ignoring fixed manufacturing overhead costs, variable costing may understate a product’s overall cost. The manufacturing overhead is important because, though the costs included in overhead do not contribute directly to the creation of the product, there is still some residual effect on the production which drives up the cost to produce.

Absorption Costing Disadvantages and Advantages:
>>In contrast to the variable costing method, absorption costing may provide a fuller picture of a product’s cost by including fixed manufacturing overhead costs.
>>A proponent of this method would argue that it is most effective because, simply enough, all the possible costs are included. What this method does is give a company or organization a more accurate view of the products importance from an economic standpoint.
>>If the product is turning over a good amount of revenue in the absorption costing method, that means that it is turning over revenue in addition to the unrelated costs of production. >>However, absorption costing ignores the differential usage of indirect resources across products or product lines.
>>Also, absorption costing can be used as an accounting trick to increase net income by moving fixed manufacturing overhead costs from the income statement to the balance sheet simply by increasing production volume disproportionately to sales volume.

Absorption Costing GAAP
Absorption costing is required for external reporting by GAAP.


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