Lesson: Absorption Costing vs. Variable Costing
Absorption costing and variable costing are two different methods of accounting for costs. Absorption costing includes both fixed and variable costs in the cost of a product, while variable costing includes only variable costs. Absorption costing is typically used for external reporting, such as financial statements, and for income tax purposes, while variable costing is primarily used for internal decision-making. The main difference between the two is that absorption costing allocates fixed costs over a period of time, whereas variable costing assigns all costs to the period in which they occur.
Updated: May 31, 2022 Create an accountAbsorption costing and variable costing are two different methods of accounting for costs. Absorption costing includes both fixed and variable costs in the cost of a product, while variable costing includes only variable costs. Absorption costing is typically used for external reporting, such as financial statements, and for income tax purposes, while variable costing is primarily used for internal decision-making. The main difference between the two is that absorption costing allocates fixed costs over a period of time, whereas variable costing assigns all costs to the period in which they occur.
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We're going to start off talking about cost accounting methods by discussing the all too important absorption costing versus what? We have three names here. These names are all the same synonyms. So variable costing is the same as direct costing, same as contribution costing. Much more likely to hear variable or direct, but just know that it's also known as contribution costing.
All right, so what are these two methods? It seems a little complex, doesn't it? My job is to be here to tell you it really isn't, not at all. I'm here to demystify it for you. It's sort of the same as what we've seen with spoilage and product versus periodic costs.
One method capitalizes costs, and the other method expenses costs. It's almost as if this is just really important. They want you to know it. There actually are a good amount of questions about this. I would definitely know it all. Absorption costing is this is another topic that was never explained to me too well and it was just, oh, very lofty explanations and super theoretical and PhD level explanations.
But all absorption costing is, it's a method where you capitalize your fixed costs under variable or direct or contribution. And I'm just going to call it variable or direct. There's a lot of names for it. You just expense fixed costs. That's all it is. All it is. Everything below this is just an effect of what happens and I'll explain them again.
Under Absorption Costing, say we're making chairs in a factory. This doesn't affect materials, labor or anything. If there's fixed costs, sure. But if we have fixed costs such as $1,000 a month to keep the lights on, those are actually, again, capitalized to our chairs, right, our inventory. And we add that