Absorption Costing vs. Variable Costing: An Overview
Absorption costing includes all the costs associated with the manufacturing of a product, while variable costing only includes the variable costs directly incurred in production but not any of the fixed costs. 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. Absorption vs. variable costing is not optional for public companies because they are required to use absorption costing due to their GAAP accounting obligations.
Before looking at absorption vs. variable costing, it will be 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 and will 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, and other.
- Absorption costing includes all of the direct costs associated with manufacturing a product, while variable costing can exclude some direct fixed costs.
- Absorption costing, also known as full costing, entails allocating fixed overhead costs across all units produced for the period, resulting in a per-unit cost.
- Variable costing includes all of the variable direct costs in COGS but excludes direct, fixed overhead costs.
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 required under GAAP.
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, like: the cost of raw materials, the hourly cost of labor, the salaries of manufacturing workers, and the variable costs of electricity used to run a plant in manufacturing mode. This also includes any direct, fixed costs, like: the mortgage payment on a building used for manufacturing, insurance on a manufacturing property, and 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 directs costs are subtracted from revenue to arrive at the gross profit.
Using the absorption costing method will increase COGS and therefore decrease gross profit per unit produced. This means company’s 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. Most auditors and financial stakeholders will also 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.
Some private 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 remain the same in both absorption and 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. With variable costing, gross profit will be slightly higher, resulting 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, which can be an advantage.
Most companies will use the absorption costing method if they have COGS. For many companies, managers will find that they are required under GAAP to use absorption costing and therefore find it most efficient to use this method only.
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. Overall, managers should be aware that absorption costing and variable costing are available as 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 will need to transition to absorption costing at some point, which can be important to factor into short-term and long-term decision making.