Variable costing vs Absorption costing.

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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,
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b) In P2 & P5, the absorption costing produces higher profits compared to marginal costing profits.

c) The marginal costing profits in P3 & P6 reports greater profits than the absorption costing profits.

The reasons for these changes are that, with a system of variable costing, profit is a function of sales volume only, when the selling price and cost structure remain unchanged. The principles of marginal costing denotes that since fixed costs relate to a period of time and does not fluctuates in sales volume, it is misleading to charge units of sale with a share of profits. However, with absorption costing, profit is a function of both sales volume and production volume. Absorption costing argues that fixed manufacturing costs are product costs. It assumes fixed costs expire with the passage of time regardless of production activity and that these costs are incurred for the benefit of operations during a given period of time. This benefit is unchanged by the actual level of operations during the period, and the benefit expires at the end of the period.

Arguments in support of absorption costing

In support of absorption costing, it is argued that the system does not understate the importance of fixed costs. All fixed production costs incurred are deemed fair if all
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