Chapter 7, Problem 1Q

What is the difference between absorption costing and variable costing?

To determine

To discuss:

The difference in absorption costing and variable costing

Absorption costing and variable costing are two different methods of determining cost of a product.

Explanation of Solution

Solution:

In absorption costing we are charging fixed manufacturing overheads as product cost while in variable costing we are treating fixed manufacturing overheads as period cost.

Explanations:

Absorption Costing:- In this type of costing method, costs are absorbed in the product units irrespective of their nature. In other words, all fixed and variable costs are absorbed in the products. It is based on the principle that costs should be charged or absorbed to whatever is being costed, whether it is a cost unit, cost center.

Variable Costing: - In Variable costing, distinction is made between expenses which vary in relation to level of production and those that do not vary linked to Production. The expenses which vary in relation to production are called variable expenses and those which do not change with level of production are called Fixed Expenses. Sales − Variable expenses = contribution is the key to calculate break Even level and ascertain margin of safety.

In case of Absorption costing our cost format is as under:

Detail	Amount
Sales
Cost of Goods Sold
Gross Profit
Selling and Administrative Expenses
Net Profit

In case of variable costing cost format is as under:

Details	Amount
Sales
Variable cost
Contribution
Fixed Cost
Net Profit

In case of Absorption costing all overheads are classified either as Production Overheads, Administrative Overheads, Selling and Distribution Overheads. Further distinction is not made whether they are Fixed or variable.

In case of variable costing − all overheads are classified between Fixed or variable depending upon their variability in relation to production units.

In case of Absorption Costing − inventory valuation includes share of all production overheads whether fixed or variable.

In case of Variable costing − inventory valuation includes share of variable production overheads. Fixed production overheads are charged as period cost.

Conclusion

In absorption costing fixed manufacturing overheads are treated at Product cost and therefore also included in value of Inventory. In variable costing Fixed manufacturing overheads are treated as Period cost and not included in closing inventory valuation.