Management Accounting: Absorption vs. Variable Costing
This costing system is also known as full costing, and it refers to a costing methodology whereby all the costs that are incurred in the production process are incorporated into the respective product costs. Therefore, “the direct labor cost, direct material costs, fixed and variable overhead costs incurred in the manufacturing process are included in the cost of the product.” However, fixed and variable administrative and selling costs are excluded in absorption costing. The main objective of absorption costing is to determine the total cost of production. Moreover, absorption costs enable accountants to determine upstream and downstream costs that are related to a specific product. Absorption costing is also used in the process of setting pricing formulas, viz. cost-plus pricing.
This terminology refers to a costing methodology that only takes into account variable costs in the process of determining product prices. Under variable costing, the total cost of production depends on the level of activity. Variable costing is also known as marginal costing. Another unique characteristic of variable costing is that it takes into account selling and administrative costs. Absorption costing is superior compared to variable costing. First, absorption costing enables managerial accountants to undertake long-run product pricing. Moreover, the information necessary to undertake absorption costing is readily available in organizations’ books of accounts. Thirdly, absorption costing enables firms’ management teams to determine product prices, hence providing a clue on an organization’s profitability. On the other hand, variable costing can only be used in the process of making short-term pricing decisions. Therefore, an organization cannot be in a position to forecast its future performance with regard to profitability.