Variable Costing Vs Absorption Costing Essay

1147 words - 5 pages

Definition

Absorption 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 costing

Before 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 price10

Unit variable cost 6

Fixed costs for each period 300

Normal activity = 150 units per period, production & sales are as follows:-

P1 P2 P3 P4 P5 P6

Units sold150120180150 140160

Units produced150150150150170 140

There 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 1

Variable costing statements:

P1P2P3P4P5P6

($)($)($)($)($)($)

Opening stock--180 --180

Production cost900 900 900 900 1020 840

Closing stock-(180)--(180)(60)

Cost of sales900 720 1080 900 840 960

Fixed costs300 300 300 300 300 300

Total costs1200 1020 1380 1200 1140 1260

Sales1500 1200 1800 1500 1400 1600

Gross profit300 180 420 300 260 340

Less non-manufacturing costs100 100 100 100 100 100

Net profit200 80 320 200 160 240

Exhibit 2

Absorption costing statements:

P1P2P3P4P5P6

($)($)($)($)($)($)

Opening stock--240 --240

Production cost1200 1200 1200 1200 1360 1120

Closing stock-(240)--(240)(80)

Cost of sales1200 960 1440 1200 1120 1280

Adjustment (over/under recovery)

of overheads(40)20

Total costs1200 960 1440 1200 1080 1300

Sales1500 1200 1800 1500 1400 1600

Gross profit300 240 360 300 320 300

Less non-manufacturing costs100 100 100 100 100 100

Net profit200 140 260 200 220 200

When 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...

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