What is the basic difference between direct costing and absorption costing?

Variable cost is the accounting method in which all the variable production costs are only included in product cost. In contrast, Absorption costing is where all the absorbed costs are taken into account. Under this method, all the fixed and variable production costs are deducted, and then fixed and variable selling expenses are deducted.

Variable costing is an accounting method for production expenses where only variable costs are included in the product cost. In contrast, Absorption costingAbsorption CostingAbsorption costing is one of approach which is used for the purpose of valuation of inventory or calculation of the cost of the product in the company where all the expenses incurred by the company are taken into the consideration i.e., it includes all the direct and indirect expenses incurred by the company during the specific period.read more includes all costs associated with a production process assigned to the units produced.

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Source: Variable Costing vs Absorption Costing (wallstreetmojo.com)

• Variable costing consists of direct material costs, direct labor costs, and variable manufacturing overheadsManufacturing OverheadsManufacturing Overhead is the total of all the indirect costs involved in manufacturing a product like Property Tax on the production premise, Remunerations of maintenance personnel, Rent of the manufacturing building, etc. read more, whereas, Absorption costing consists of direct material costs, direct labor costs, variable manufacturing overheads, and fixed manufacturing overheads.
• Under variable costing, there is no concept of over and under absorption of overheads. Under absorption costing, fixed costs are absorbed on an actual basis, or on the basis of the predetermined ratePredetermined RatePredetermined overhead rate is the distribution of expected manufacturing cost to the presumed units of machine-hours, direct labour hours, direct material, etc., for acquiring the per-unit expense before every accounting period.read more based on normal capacity.

Table of contents

• Difference Between Variable and Absorption Costing
  • Variable vs Absorption Costing Infographics
  • Key Differences
  • Variable vs Absorption Costing Comparative Table
  • Conclusion
  • Recommended Articles

Variable vs Absorption Costing Infographics

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Source: Variable Costing vs Absorption Costing (wallstreetmojo.com)

Key Differences

It is important to gauge the key differences between these costing. This will give us additional clarity on the subject matter.

• The key difference will be clear through an example. Let us assume that an organization makes 1000 units of a product. It incurs Rs.2 for direct material, Rs.1 for direct labor, and Rs.2 for variable factory overheadFactory OverheadFactory Overhead, also called Factory Burden, is the total of all the indirect expenses related to the production of goods such as Quality Assurance Salaries, Factory Rent, & Factory Building Insurance etc. read more.  It additionally incurs a fixed factory overhead of Rs.1000. Here, the product cost under variable costing will be Rs.5 (2+1+2). Under absorption costing, fixed factory overhead of Rs.1000 will also be allocated over 1000 units, increasing to Rs.1 per unit. Thus, the product cost under absorption costing will be Rs.6 (5+1).
• Now let us see how variable costing helps in making managerial decisions. Suppose the organization gets an order of 50 additional units of a product at Rs.5.50 per unit selling price. No additional cost would be incurred on orders. Should the company accept the order? The company might reject the order based on absorption costing as a loss of Rs.0.50 (5.50-6) per unit is made. But, fixed factory overhead won’t increase for producing additional units. Hence, the decision to reject the order is flawed. The profit would be Rs.0.5 (5.50-5) based on variable costing. Hence, the organization should accept the order based on variable costing, which is the right decision.
• Variable costing is used to make managerial decisions such as which product to discontinue, determine product mix, make or buy decisionsMake Or Buy DecisionsA Make or Buy Decision is a decision to either manufacture a product/ service in house or buy it from outside suppliers (outsourcing) based on cost-benefit analysis. A planned decision can be made using quantitative or qualitative research.read more, and how to price a product. In addition, variable costing is used for finding a margin of safety, optimal capacity utilization rate, and the degree of operating leverage. Variable costing is used for calculating the break-even point based on the cost-volume-profit analysis. The break-even point is the level where there are no profits/losses. Variable costing helps in determining the contribution margin of a productContribution Margin Of A ProductThe contribution margin is a metric that shows how much a company's net sales contribute to fixed expenses and net profit after covering the variable expenses. As a result, we deduct the total variable expenses from the net sales when computing the contribution.read more. Absorption costing does not help in making these managerial decisions. But, the pricing policy determined following absorption costing ensures that all costs are covered.
• Since absorption costing is to be utilized for external reporting, it may be used as the sole method of accountingMethod Of AccountingAccounting methods define the set of rules and procedure that an organization must adhere to while recording the business revenue and expenditure. Cash accounting and accrual accounting are the two significant accounting methods.read more. Thus, an organization can completely do away with variable costing. This will help reduce the burden of accounting. But if it does so, it will miss out on certain key insights available from variable costing. Variable costing is not recognized for external reporting as it does not uphold the matching principleMatching PrincipleThe Matching Principle of Accounting provides accounting guidance, stating that all expenses should be recognized in the income statement of the period in which the revenue related to that expense is earned. This means that, regardless of when the actual transaction is made, the expenses that are entered into the debit side of the accounts should have a corresponding credit entry in the same period.read more about inventory. Undermatching principle, related expenses should be recognized in the same period as related revenue. The supporters of variable costing argue that no fictitious profit can arise due to the fixed cost being absorbed in unsold stock. This leads to a realistic valuation of a stock.
• In absorption costing, since a considerable amount of overhead costsOverhead CostsOverhead cost are those cost that is not related directly on the production activity and are therefore considered as indirect costs that have to be paid even if there is no production. Examples include rent payable, utilities payable, insurance payable, salaries payable to office staff, office supplies, etc.read more are allocated to the product, a significant proportion of the product’s cost may not be directly traceable to the product. The management can also push forward costs to the subsequent period when the products are sold. Under absorption costing, managers can improve their profit performance by building up inventory. This does not reveal an accurate picture. One of the limitations of variable costing is that it becomes very difficult and cumbersome to apply in cases where there are large stocks of work-in-progress inventory.

Variable vs Absorption Costing Comparative Table

BasisVariable CostingAbsorption CostingCostsVariable costing includes only variable costs directly incurred in production.Absorption costing includes both variable costs and fixed costsFixed CostsFixed Cost refers to the cost or expense that is not affected by any decrease or increase in the number of units produced or sold over a short-term horizon. It is the type of cost which is not dependent on the business activity.read more related to production.Alternative NamesVariable costing is also known as marginal costing or direct costing.Absorption costing is also known as full costing.Internal / External UseVariable costing is generally used for internal reporting purposes. Managerial decisions are taken on the basis of variable costing.Absorption costing is used for reporting to the external stakeholders as well as for the purpose of filing taxes. It is in line with GAAPGAAPGAAP (Generally Accepted Accounting Principles) are standardized guidelines for accounting and financial reporting.read more (Generally Accepted Accounting Principles) and IFRS (International Financial Reporting Standards).RelevanceVariable costing is used for comparing the profitability of different product linesDifferent Product LinesProduct Line refers to the collection of related products that are marketed under a single brand, which may be the flagship brand for the concerned company. Typically, companies extend their product offerings by adding new variants to the existing products with the expectation that the existing consumers will buy products from the brands that they are already purchasing.read more. The organization can carry out an analysis based on costs, volumes, and profits.Absorption costing is used for calculating per unit cost based on all costs including fixed overhead costs.ReportingVariable costing is based on internal specifications of reporting and presentation.Absorption costing is based on external reporting standards given by external agencies.InventoryVariable costing involves only variable production costs to be assigned to inventory, work-in-progress, and cost of goods sold.Absorption costing involves considering all production costs and including them in inventory and work-in-progress.ContributionVariable costing calculates contribution which is the difference between sales and variable cost of sales.Absorption costing is used to calculate the net profit.ProfitProfit is much easier to predict as it is a function of sales.It is much more difficult to predict the effect of change in sales on profit.

Conclusion

Though variable costing aids in managerial decisions, it should not be the sole basis. The management should look at different perspectives, including absorption costing data. The management should look at consumer insights, relation with buyers, the effect on brand-building, and other factors while making decisions. While calculating net profit, a manager should look at both costing techniques.

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