Absorption and Variable cost accounting methods
Both absorption and variable cost accounting methods are important in determining and allocating costs in a manufacturing company. Absorption cost accounting method uses all costs in a manufacturing company, while, allocating costs, regardless of whether they are fixed or variable. The cost of a unit product, in absorption costing, includes direct labor cost, direct material cost, and variable, as well as, fixed overhead. This method is also known as full allocation cost accounting method because it includes both fixed costs and variable cost in every produced product.
On the other hand, the variable cost accounting method allocates only the direct costs, variable costs, when determining the cost of products. Variable cost means that when the output produced increases the cost of production increases, directly. The method includes direct material and labor costs, as well as, variable overhead costs while determining cost per unit produced. In the variable cost accounting method, the fixed costs treated as a periodic cost i.e. they are added together to be fixed costs of an accounting period. Examples are distribution costs, selling costs, and administration costs. The costs are deducted from the accounting period revenue to determine the net profit. In both cost accounting methods, variable and absorption, all costs, fixed and variable, are deducted as expenses, for a specific accounting period, but the methods of determining the cost per unit produced, and the entire cost of production are different.
The Generally Accepted Accounting Principles (GAAP) requires absorption cost to be used by all manufacturing companies, for external reporting. The income statement must include only the variable cost of production, and part of fixed cost in calculating the gross profit. Most tax authorities require every manufacturing company to use the absorption cost accounting method in its accounting reporting. This is because, for example if the company sells a small portion of the units produced, and deducts the entire period fixed costs, the net profit would be insignificant and the firm ends up paying less tax.
Most managers depend on variable costs accounting method, internally, for decision-making. Bruegelmann states that “managers are able to see how total fixed cost affects their business performance if the units sold were few (120)”. If a company does not sell all of its units produced, the net profit reduces. To tackle the problem, the company must cut down its fixed costs or formulate an aggressive marketing strategy to boost sales.
Both absorption and variable cost accounting methods employ accrual basis accounting procedures while allocating cost. In other words, all the costs, fixed and variable are allocated as soon as they are incurred. This is regardless if the cash has been received. Additionally, under variable cost accounting method, the unit cost of production is undervalued. This is because the fixed overhead costs are not allocated in determining the cost of production. On the other hand, absorption method gives more accurate costs of the units produced since they include both fixed and variable costs.
Pricing decisions also differ for absorption and …