Variable Costing Vs Absorption Costing Essay

1147 words - 5 pages

DefinitionAbsorption costing, also known as full costing refers to a system in which all the fixed manufacturing overheads are allocated to products. The alternative system which assigns only variable manufacturing costs to products then fixed costs added separately is termed marginal costing.Variable costing vs. Absorption costingBefore discussing the arguments for absorption costing, an illustration of both methods would provide a better comparative insight of major differences using the examples below:-The following information is available for periods 1-6 for a company that produced a single product($)Unit selling price10Unit variable cost 6Fixed costs for each period 300Normal activity = 150 units per period, production & sales are as follows:-P1 P2 P3 P4 P5 P6Units sold150120180150 140160Units produced150150150150170 140There were no opening stocks for P1, actual manufacturing fixed overhead incurred was $300 and non-manufacturing overheads are $100 per period.The variable and absorption cost statements for periods 1-6 are shown in Exhibits 1 and 2.Exhibit 1Variable costing statements:P1P2P3P4P5P6($)($)($)($)($)($)Opening stock--180 --180Production cost900 900 900 900 1020 840Closing stock-(180)--(180)(60)Cost of sales900 720 1080 900 840 960Fixed costs300 300 300 300 300 300Total costs1200 1020 1380 1200 1140 1260Sales1500 1200 1800 1500 1400 1600Gross profit300 180 420 300 260 340Less non-manufacturing costs100 100 100 100 100 100Net profit200 80 320 200 160 240Exhibit 2Absorption costing statements:P1P2P3P4P5P6($)($)($)($)($)($)Opening stock--240 --240Production cost1200 1200 1200 1200 1360 1120Closing stock-(240)--(240)(80)Cost of sales1200 960 1440 1200 1120 1280Adjustment (over/under recovery)of overheads(40)20Total costs1200 960 1440 1200 1080 1300Sales1500 1200 1800 1500 1400 1600Gross profit300 240 360 300 320 300Less non-manufacturing costs100 100 100 100 100 100Net profit200 140 260 200 220 200When a system of variable costing is used (Exhibit 1), the product cost is $6 per unit, and only includes variable costs since only variable production costs are allocated to the product. Fixed costs of $300 are then added separately to produce a total manufacturing cost of $1200 and are charged in the period in which they incurred. By using the absorption costing method (Exhibit 2), fixed overheads are allocated to individual products and are included in the production costs. The product cost now consists of variable cost plus a fixed manufacturing cost, making a total of $8 per unit. The production cost for P1 (150 units at $8) is $1200.As depicted in P2, under the variable costing system, a closing stock of 30 units will be valued at $6. Closing stock of $180 will then be deducted from the production costs, giving a cost of sales figure of $720. The closing stock valuation here does not include any fixed overheads. With the absorption costing, fixed cost is included in the production cost figure; hence note the closing stock of 30...

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