Variable and Absorption Costing

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Variable costing and absorption costing are the two most commonly used methods of inventory costing for manufacturing companies. The inventory method of variable costing takes place when total direct and indirect variable manufacturing costs are included within inventoriable costs. Fixed manufacturing costs however, are considered costs of the period under variable costing. The next method of inventory costing, absorption costing, includes all variable manufacturing costs as well as fixed manufacturing costs in inventoriable costs. These costs are said to be “absorbed” by the product. These two methods hold some similarities, but they are also very different from one another and each affect a company’s operating profit differently.

When it comes to absorption costing, the first thing that must be determined is a specific amount of fixed manufacturing overhead costs. The manufacturing overhead are all of the expenses incurred through the manufacturing process. The manufacturing overhead costs will be applied to each unit of output. These costs include, but are not limited to, direct materials, direct labor, applied variable manufacturing overhead and applied fixed manufacturing overhead. This fixed overhead cost per unit is recorded as ‘Cost of goods sold’ upon the sale of each unit.

Conversely, under variable costing, the manufacturing costs per unit only include variable costs such as direct materials, direct labor and applied variable overhead. For this reason, it is essential that the total manufacturing overhead costs are divided into fixed and variable costs. All of these costs are expensed in their current accounting period, regardless of how many units were sold. With variable costing, the total fixed costs incurred will remain constant regardless of the level of output.

An issue between these two costing system on based on timing—the time when fixed manufacturing costs are charged against revenue when units are sold in absorption costing, or the...
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