Absorption and Variable costing are very important tools for cost accounting. Both of these costing methods allow you to see the cost of your inventory, in a different way. For example the absorption method allows you to assign all costs to the product, while variable costing allows only variable costs to be assigned to the product. Inventory management is extremely important as well because it ties into efficiency and lowering your costs so that your company can be as profitable as it can in operations. Throughout this paper I will discuss the importance of both costing methods, how it is implemented as well as using the income statement for costing.
Most companies don’t necessarily look at the costs of all departments; they break down the departments into separate entity’s called profit centers. The companies do this because by breaking down each department they can see if there are any problem areas that they should correct, involving the performance of the individual profit centers. To look at the overall company’s performance, most people find it useful to look at the income statement. However, this income statement is of little use for determining the viability of the individual business units or segments. Instead, it is important to develop a segmented income statement for each profit center. That is why these two costing methods have been developed. One of them is based on variable costing and the other is based on absorption costing. They are costing methods because they refer to the way in which product costs are determined. Product costs are inventoried; and they include direct materials, direct labor and overhead. Period costs are expensed in the period they are incurred. These are usually selling and administrative expenses or other expenses to run your company day to day. The one difference between the two costing systems is fixed factory overhead.
Absorption costing is a costing system that assigns all manufacturing cost to the produce, including fixed factory overhead. Absorption costing includes direct materials, direct labor, variable overhead, and fixed overhead. The four costs define the cost of the product. Under absorption costing, fixed overhead is viewed as a product cost, not a period cost. Fixed overhead is assigned to the product through the use of predetermined fixed overhead rate and is not expensed until the product is sold. Absorption costing has product costs of direct materials, direct labor, variable overhead, and fixed overhead. While the period costs include just selling and administrative expenses.
Variable costing assigns only the variable manufacturing costs to the product; these costs include direct materials, direct labor, and variable overhead. As you can see variable costing stresses the difference between fixed and variable manufacturing costs. Fixed overhead is than treated as a period expense and is excluded from the product cost. The reason for this is because fixed overhead is a cost of staying in business. After the period is over, any benefits provided by this capacity are expired and are not inventoried. Fixed overhead of any period is than seen as expiring in that period and is charged in total against revenues for the period. The product costs for variable costing include direct materials, direct labor and variable overhead. The period costs include fixed overhead, and selling and administrative expenses.
Now we move onto the relationship between the variable costing income and the absorption costing income. The relationship changes as the production and the sales change. If you sold more than was produced, variable costing income is greater than the absorption costing income. But if you sold more than you produced that would mean that you were selling the beginning inventory and units produced. Under the absorption method, the units that are coming out of the inventory...