Introduction
Absorption costing is a method of calculating total production costs of a company that goes beyond what is found on the income statement and takes into account both fixed and variable costs associated with making a product or providing a service. This method of calculating costs can provide a more accurate picture of a companys true expenses, as it gives a more comprehensive view of the costs that go into producing a particular product or offering a certain service.
In contrast, variable costing, sometimes referred to as direct costing or marginal costing, is a method of assigning costs to items or services produced by a business. This method only accounts for the costs of the direct materials, direct labor, and variable overhead associated with production, excluding any fixed overhead costs.
Overview of Absorption Costing
Absorption costing is an accounting method used to accurately determine the total production cost of a product. This method incorporates fixed and variable costs associated with production, such as raw materials, labor, overhead, and selling and administrative expenses. These production costs are spread over the total number of units produced, which is why it is also known as full costing or overhead absorption.
When using absorption costing, fixed overhead costs are absorbed as part of the cost of each product. These costs are usually fixed during a certain time period and are usually not changed by the production level. For example, if the overhead cost of a factory is $200,000 per year then it will be spread out over the units produced that year, regardless of the level of production. This method of accounting allows companies to accurately determine the cost of production, giving a more accurate picture of their true costs.
Overview of Variable Costing
In contrast to absorption costing, variable costing is a method of assigning costs to items or services produced by a business. This method is used to assign only the costs of the direct materials, direct labor, and variable overhead associated with production, excluding any fixed overhead costs. Variable costing is often used to analyze the profitability of different products that are offered by a business, as it gives a more accurate view of the actual costs associated with producing a particular product or offering a certain service.
For example, if a company is producing a widget and requires $2 of direct materials and $5 of direct labor to make one widget, then using variable costing would show the cost to make one widget as $7. This method does not take into account any overhead costs, such as rent or utilities, as these costs are not directly related to the production of the widget. This method gives a more accurate picture of the cost to produce the widget and can be used to compare with projected sales price or cost of goods sold to determine the profitability of the product.
Conclusion
Absorption costing and variable costing are two methods of calculating total production costs for a company. Absorption costing takes into account fixed and variable costs associated with producing a product or providing a service, whereas variable costing only assigns costs to items or services produced by a business that are related to the direct materials, direct labor, and variable overhead associated with production. Both methods are useful in helping companies to better understand their production costs and analyze the profitability of their products and services.
