Absorption costing includes all costs, including fixed costs, related to production, while variable costing only includes the variable costs directly incurred in production. Companies that use variable costing keep fixed-cost operating expenses separate from production costs.
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 overhead costs involved in manufacturing the product, such as batteries to run machinery.
The fixed costs that differentiate variable and absorption costing are primarily overhead expenses, such as salaries and building leases, that do not change with changes in production levels. A company has to pay its office rent and utility bills every month regardless of whether it produces 1,000 products or no products at all, for example.
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 — unlike variable costing, which combines all fixed overhead costs into one expense, reporting them as a single line item on a balance sheet to be taken against net income. In contrast, absorption costing will result in two categories of fixed overhead costs: those attributable to the cost of goods sold and those attributable to inventory.
Absorption Costing vs. Variable Costing: Pros and Cons
Whichever costing method a company selects to use for accounting purposes, there are advantages and disadvantages.
Variable costing can make it more difficult to determine ideal pricing for its goods and services since it does not directly consider all of the costs the company has to cover to be profitable. However, by looking only at the costs directly associated with production, variable costing makes it easier for a company to compare the potential profitability of manufacturing one product over another.
One of the big advantages of absorption costing is that it is the method required for a company to be in compliance with generally accepted accounting principles (GAAP). Even if a company decides to use variable costing in-house, it is required by law to use absorption costing in any external financial statements it publishes. Absorption costing is also the method that a company is required to use for calculating and filing its taxes. Some might argue that since a company has to use absorption costing anyway, it might as well make that its sole approach – as opposed to taking on the additional burden of keeping variable costing books.
Absorption costing also provides a more accurate accounting of net profitability, especially when a company doesn't sell all of its products in the same accounting period when they are manufactured. Every expense is allocated to products manufactured whether or not they are sold.
However, absorption costing is not as helpful as variable costing for comparing the profitability of different product lines. Variable costing, on the other hand, enables a company to run a cost-volume-profit analysis. This analysis is designed to reveal the break-even point in production by determining how many products a company must manufacture and sell to reach the point of profitability.