Costing is a measurement of the actual cost of a product or service. It is a tool that allows an organization to track its costs. Costing and budgeting are two terms that are often used interchangeably. They are different, however, in the way they are used. Costing is a tool that helps you track your expenses. It helps you identify areas where you can reduce costs. Budgeting is the process of estimating the costs of a project or the expenses you expect to incur in the future.

Costing is a way to measure the costs of your products and services. It is also used to determine the prices of those products and services. It is also used to determine the profitability of a business. When it comes to measuring the cost of manufacturing processes, several methods can determine the cost of manufactured goods.

In this article, we are going to discuss two commonly used costing methods, which are

  • Absorption Costing
  • Variable Costing

What is Absorption Costing?

The term “absorption costing” describes the method of accounting for a cost that is applied in vertically integrated organizations. It is also referred to as the “all-inclusive” method of accounting for costs.

In straightforward terms, absorption costing is how the total cost of production comprises the direct costs of production and overhead costs.

Under absorption costing, the cost of production is composed of three components:

  • Cost of direct materials (e.g. materials used to make the product, such as steel)
  • Cost of direct labor (e.g. the salary of the workers who produce the product)
  • Cost of capital or fixed costs (e.g. the cost of machinery and other equipment)
  • Overhead costs which are in addition to these costs, the manufacturer has a cost of selling the product. This is the cost of the retailer’s labor and overhead. It is often called “overhead” because the retailer’s labor and other expenses are not really part of the manufacturing process.
Related article  The Bottleneck In Production - What Is It and How to Deal With It?

The “cost of manufacturing” is the total of these four components.

Let us look at an example now:

Let us assume that the total production units are 1000 and the cost card is as follows.

 USD
Direct Variable Costs 
Direct labor55,000
Direct materials29,000
Prime Cost84,000
Indirect Costs 
Indirect labor8,500
Indirect materials12,500
Depreciation4,000
Factory rent9,000
The total cost of production118,000
Fixed Costs 
Fixed selling expenses22,000
Fixed administration expenses35,000
Total cost175,000

This is the cost card under absorption costing. If we want to find out per unit cost, we have to divide the total cost by the total units, i-e 175000/1000 = $175

From this example, we can see that the variable costs are $84 (84000/1000). This means that if we increase the production by a further 10 units, the total cost will increase to $175,840 because the cost of 10 extra units would be $840.

This means that manufacturing 10 additional units would bring the per-unit cost to $174 (175840/1010).

Therefore, as we increase the number of units, the per-unit cost under absorption costing will reduce because each extra unit of production will absorb the fixed costs of production.

In simple words, under absorption costing, if fewer units are produced, each unit will have to absorb a large share of the total fixed cost, but if a large number of units are produced, then each unit will absorb a small share of the total fixed cost. This is why per-unit costs are low in absorption costing systems.

Related article  Pay What You Want Pricing (PWYWP) - How Does It Work?

Absorption costing is, therefore, a system of costing where in addition to the variable costs, the fixed costs of production are also absorbed into the cost of the product.

What is Variable Costing?

If you have understood absorption costing, then variable costing should be a straightforward concept to understand. As the name suggests, variable costing is a method of costing that focuses on the product’s variable costs being manufactured.

Suppose we look at the example discussed above. We can see that the prime cost is the total variable cost of production. The main difference between absorption and variable cost of production is in the treatment of fixed costs.

Under a variable costing system, only the direct production costs are considered part of the cost of production. The fixed and indirect costs of production are not seen as part of the cost of production.

Why?

Because fixed costs remain the same at every production level till the maximum capacity of production is reached. Since the fixed cost does not change with variation in the production units, it is not considered a direct contributor to the cost of production.

This is why variable costing is seen as a more accurate indicator of the per-unit cost of production. If you look back at the example of absorption cost, you will see that the per-unit cost of production is reduced as units are increased.

This brings uncertainty for management decisions, which is why businesses usually use variable costs for internal decision-making and absorption costing to communicate the costs to various stakeholder groups.

Related article  What is a Joint Product? Definition, and Example

The management can make better decisions if the per-unit cost stays constant, which happens with variable costs. On the other hand, the stakeholders can understand the cost breakup and financials better if they look at the overall cost of the business and how each unit is absorbing the overheads.

To conclude this discussion, both absorption and variable costs are commonly used methods of production cost analysis. The major difference between both methods includes the fixed cost as a part of the total cost. Both methods appeal to different stakeholder groups.