A costing includes all costs associated with producing a product, while a variable costing includes only the variable costs directly incurred in the production process but does not include fixed costs. Absorption costing is mandatory under the Financial Accounting Standards Board’s Generally Accepted Accounting Principles (GAAP).
Absorption and variable costing are factors only for companies that report costs of goods sold (COGS) on the income statement. Absorption and variable costing are not optional for public companies because they are required to use absorption by virtue of their GAAP accounting obligations.
- Costing includes all direct costs associated with product production, while variable costing may exclude some direct fixed costs.
- Costing, also known as full costing, involves allocating fixed overhead costs to all units produced in a period, resulting in a unit cost of production.
- Variable costing includes all variable direct costs in COGS but excludes directly fixed overhead.
Before considering absorption and variable costing, it is important to understand the difference between direct and indirect costs in the income statement. Direct costs are usually related to COGS, which affect a company’s gross profit and gross profit margin. Indirect costs are related to a company’s operating expenses and significantly impact operating profit and operating profit margin.
Some of the direct costs associated with producing products include the wages of employees physically producing the products, raw materials used to produce the products, and direct overhead costs associated with producing the products.
Indirect costs are not directly related to production. They can include:
- Administrative expenses
- Amortization of intangibles
- Marketing expenses
- Other expenses
- Research and development
- Selling expenses
- Some depreciation
The absorption cost method is also known as the full cost method. Public companies should use the absorption costing method in managing COGS cost accounting. Many private firms also use this method because GAAP requires it.
The absorption costing method involves allocating all direct costs associated with producing a product to COGS. This includes any variable costs directly related to production, such as:
- Cost of raw materials
- The hourly cost of labour
- Salaries of manufacturing workers
- The variable costs of electricity consumed to run a plant in production mode
It is also includes any direct, fixed costs, such as:
- Depreciation of a manufacturing machine
- A manufacturing building’s mortgage payment
- Insurance on a manufactury
Depending on a company’s level of transparency, variable direct costs and fixed direct costs may be split into two line items or combined to present an overall COGS figure in the income statement using the absorption calculation method. Variable direct and fixed direct costs are subtracted from revenue to arrive at a gross profit in either case.
Using the absorption cost method will result in an increase in COGS and, therefore, a decrease in gross profit per unit produced. This means that companies will have a higher break-even production price per output unit. It also means that customers will pay a slightly higher retail price. It also means that companies are likely to show lower gross profit margins.
The impact of costing varies from company to company. For example, a company must make monthly mortgage payments on a manufacturing property whether it produces 1,000 units. The company may increase gross profit after the mortgage payment is made, or the depreciation schedule for production equipment is completed. When using the absorption costing method, accountants should closely watch these aspects.
The absorption costing method is usually the standard for most companies with COGS. It is required for GAAP compliance. Most auditors and financial stakeholders also require it for external reporting. Depending on the type of business structure, small businesses may also be required to use the absorption costing method for tax reporting.
Some private companies may choose the variable cost method. With variable costing, all variable direct costs are included in COGS. Fixed direct costs are charged to operating expenses, not COGS. The types of fixed direct costs is the same in both absorption and variable costing:
- Mortgage payment for the building used for production
- Insurance of production property
- Depreciation of production equipment.
The break-even price per unit will be lower than with COGS with variable costing. This can make it somewhat difficult to determine the ideal price. The gross profit margin will be slightly higher with variable costing, resulting in a slightly higher gross profit margin than absorption costing.
Keep in mind that companies using the cash method may not need to recognize some of their expenses because they are not tied to revenue recognition, which can be an advantage.
Most companies use the absorption costing method if they have COGS. For many companies, managers find that GAAP requires them to use the absorption cost method and therefore find it most efficient to use only this method.
Depending on the company’s business model and reporting requirements, it may be advantageous to use the variable cost method or calculate it when reporting. In general, managers should be aware that absorption and variable costing can be chosen when analyzing a company’s COGS cost accounting process.
If a firm has high direct fixed overhead costs, this can greatly impact unit prices. Companies using variable costing may be able to allocate high monthly direct fixed costs to operating expenses. In some cases, this may result in a more reasonable unit price. However, most companies will have to switch to absorption costing, which can be an important factor in short-term and long-term decisions.