Most people, especially those in accounting would have questions to ask when it comes to absorption costing and income statements. Absorption costing is often used interchangeably with the term full costing and they are usually identified to have similar meanings.
Generally, absorption costing has to do with situations that affect the manufacturing costs of companies. It includes all product costs which are both fixed and manufacturing product costs. It is also known as a managerial account used to cover all expenses made on a particular product. Therefore, this means that an absorption cost includes all direct and indirect costs including labor, rent, insurance, etc.
The income statement divides the period and product cost to have an overview of the costs. It shows that the gross profit is less than the selling and that the administrative expenses are equal to the operating income. It also shows that the cost of goods sold is equal to the gross profit.
Absorption costing means that every product whether sold or not within a particular period has a fixed overhead cost. This means that every cost must be included at the end of an inventory and is usually done as an asset on the balance sheet. As a result of this, it is not unusual to find out that there is a lower expense on the income statement when using an absorption statement.
It is necessary to note that there would always be an imbalance in the balance sheet of absorption cost; the inventory is always higher than the expenses on an income statement. This is because an absorption cost includes the costs of manufacturing products, employees’ wages, raw materials, and every other production costs.
Therefore, to calculate the product costs under absorption cost, the direct materials, direct labor, variable and fixed overhead would be added together to produce the total product cost. These costs can also be calculated according to each unit and this is done by dividing the total product cost from the total unit produced. Fixed overhead costs can be calculated per unit because they change per unit and not in total.
Pros of absorption costing
Absorption costing has an advantage over another account format because it is the generally accepted form of accounting principle required by the internal revenue service. However, there are several reasons and benefits of absorption costing which includes but is not limited to the following:
- It helps to track profits earned during an accounting period taking into consideration all costs of production, not just the direct costs.
- It gives an overview of the fixed costs attributable to the end of an inventory.
- It gives room for accuracy especially in ending inventories. This is to prevent the loss of expenses that are linked to the full cost of inventory on the other hand.
- It ensures accountability for unsold products and gives room for higher net income calculation by reducing the actual expenses reported on the income statement for a particular period.
- It is the major method required for taxing in the United States and many other countries.
Cons of absorption costing
While we may want to acknowledge the various advantages/benefits of absorption costing such as its financial and tax reporting, we also need to know its few disadvantages/cons. Some of them include:
- It is often difficult to analyze and understand. This is because this method does not state its fixed overhead incremental costs.
- It could inflate a company’s profit during an accounting period. This is because it is not all fixed cost that is lined and removed from the companies revenue. However, an expectation could be when a company sells off all its manufactured products.
- It cannot be used to design or improve operational efficiency, not to compare product lines.
- Usually, it leads to an increase in net income because some manufactured products usually go unsold at the end of a particular period.
Absorption Costing And Variable Costing.
Both Absorptions costing and variable cost have a relationship with fixed overhead costs. However, while absorption costs shared fixed overhead costs into various units produced within a particular period, variable costing sums them all together. Variable costing also reports all expenses made with a period as a single item different from the cost of goods sold or still available for sale.
Therefore, while we can say that variable costing provides a single expense line for fixed overhead costs, we can also agree that absorption costs provide two categories for fixed overhead costs usually in the costs of goods sold and those attributed to inventory.
Absorption costing is also known as marginal costing, variable costing, direct costing, or full costing assigns all the costs of manufactured products. Variable costing which is used for cost volume and profit analysis assigns variable costs to products.
Companies, however, can get information from variable costing and absorption costing systems as long as the companies can calculate the amount of every manufacturing fixed overhead per unit.
Both variables costing and abortion costing may produce different profits due to the use of different inventories valuation techniques. These profits only differ in the presence of an opening and closing inventory.
When an opening inventory is bigger than the closing inventory, the outcome would mean that the profits in absorption will be less as a result of a relatively higher amount of fixed cost in the former.
The absorption and variable costing methods are the two major methods used by firms to increase work value in the process and also finished goods inventory for financial accounting. The variable cost could also be referred to as direct costing or marginal costing and it includes all variable costs like direct labor, direct materials, and variable overhead. Here, these variable costs are assigned to products and fixed overhead costs for some time.
The difference between variable and absorption costing is that different management prefers to use one method more for decision making than the other. Also, the absorption method is by GAAP. Fixed overhead is not always included in the value inventory of variable costing.
Variable Costing Versus Absorption Costing Methods
The difference between the absorption and variable costing methods centers on the treatment of fixed manufacturing overhead costs. Absorption costing “absorbs” all of the costs used in manufacturing and includes fixed manufacturing overhead as product costs.
Absorption costing is by GAAP because the product cost includes fixed overhead. Variable costing considers the variable overhead costs and does not consider fixed overhead as part of a product’s cost. It is not by GAAP, because the fixed overhead is treated as a period cost and is not included in the cost of the product.
Comparing Variable and Absorption Methods
A company expects to manufacture 7,000 units. Its direct material costs are 10 per unit, direct labor is 9 per unit, and variable overhead is 3 per unit. The fixed overhead is estimated at 49,000. How much would each unit cost under both the variable method and the absorption method?
The variable cost per unit is 22 (the total of direct material, direct labor, and variable overhead). The absorption cost per unit is the variable cost (?22) plus the per-unit cost of ? 7 (?49,000/7,000 units) for the fixed overhead, for a total o? 29.
Pros of variable costing:
- Variable costing is seen to provide data for CVP analysis. These data are usually provided immediately even though the fixed and variable overhead are separate items.
- Here the net income given is not affected by the changes in production volume.
- Variable costing is easier to understand because overhead changes with the cost driver.
- Since variable costing places more emphasis on the impact fixed costs have on income, these fixed costs are often more visible.
- There is often a less distorted margin because these margins are not allocated by the common fixed costs. Common fixed costs which are also known as allocated fixed costs are the organization’s costs which are usually divided by the different components of businesses that generate revenue.
- Variable costing is usually facilitated by the use of control mechanisms that are on different production levels.
Cons of variable costing:
- This method is not accepted for financial reporting under GAAP. This is because it is not recognized in the same period as its related revenue.
- The tax reporting laws of several countries like the USA require more absorption costing than variable costing.
The absorption costing income statement is also known as the traditional income statement. These traditional income statements use absorption costing to form an income statement.
Every other part of the income statement becomes easy to calculate once you have gotten your cost per unit. It is important to note that the variable items are only calculated based on the number of units sold. This means that cost can only be expensed based on the amount sold while those unsold end up in the inventory.