Absorption and Variable Costing
According to Göx (2000), absorption costing entails all costs related to the production of a product, including the fixed costs. Variable costing, on the other hand, only involves costs that increase or decrease with changes in the production level. Examples of expenses that vary with changes in the level of output include wages for employees who are directly involved in the manufacturing process of a product, the cost of raw materials used in the manufacturing process, and overhead cost directly associated with product manufacturing. Fixed cost includes utility bills and rent.
The difference between absorption costing and variable costing is, therefore, centered on the way each method treats the fixed cost. Absorption allocates all the cost, including the fixed cost to all the units produced, while the variable costing method only allocates a variable cost to the units produced.
Both methods are widely used. Each method has its merits and demerits. According to Pong and Mitchell (2006), the absorption costing method is, however, recommended for reporting by GAAP. The merits of the variable costing are summarized as being highly useful for CVP analysis, easily understandable, causes less distortion on the profit margin, and provides a mechanism for control. The disadvantages associated with this method is that the method is unacceptable for financial reporting by GAAP and tax reporting.
The advantages of absorption costing include acceptability by GAAP for financial reporting and tax purposes. Critics of this method, however, argue that absorption costing is challenging to understand as it fails to explain the additional fixed costs. The variable costing method is also criticized as being difficult in determining the appropriate price of a product as it fails to account for all the costs associated with the production of the goods or the service, whether directly or indirectly.
References
Göx, R. F. (2000). Strategic transfer pricing, absorption costing, and observability. Management Accounting Research, 11(3), 327-348.
Pong, C., & Mitchell, F. (2006). Full costing versus variable costing: Does the choice still matter? An empirical exploration of UK manufacturing companies 1988–2002. The British Accounting Review, 38(2), 131-148.