The first question that comes to mind when reading about variable and absorption costing is: why would companies use two different methods for costing? Since manufacturing cost in general is the sum of costs of all resources consumed in the process of making a product (Ostwald. 2004); isn’t it confusing to separate them into two methods? And what is more interesting is that variable cost method is used internally by the managerial accountants and absorption cost method is used by external organizations such as IRS, creditors etc.
Both costing methods are made of product cost and period cost, the difference is how the fixed cost is used. Again as a former manager of pizzeria I want to apply those methods. The pizza’s direct material cost is $5 per one pie which includes the cheese the pizza souse, the dough; the direct labor is a salary of the pizza man which is lets say calculated to $2 per pie; variable cost is a cost of the dishwashers, the refrigerators, the mixers etc. lets say it is $1; and fixed cost which is the rent calculated from yearly rent divided by the pies that we sell per year, let say it is $3 per pie—if we add them together it will be $11—it is a product cost of the absorption costing.. However, the pizza’s variable costing will be $3 less (it is a fixed cost less) which is $9. Therefore, the fixed manufacturing overhead is not used in variable costing. But it does make sense. Lets say I have two pizzerias as a chain one in lower Manhattan and one in upper and I want to set one price for both—the only way I can calculate the cost is by using the variable costing and then add the fixed overhead when I do the sale taxes once a year for both because the cost of the pizza will be the same but the fixed cost which is the rent in this case will be much more expensive in lower Manhattan then in upper.
Absorption costing offers and advantage when you do not sell all of your products during the accounting period…You do not show the expense until you actually sell the items in inventory which can improve your profit for the period (Johnston. 2014). However the advantage to variable costing is that variable costing net operating income is closer to net cash flow (Geri. 2010).
Ostwald, P. F. Mclaren, T. S. (2004). Cost analysis and Estimating for Engineering and Manegement. Pentice Hall, ISBN 978-0-13-142127-1
Johnston Kevin (2014). Advantages & Disadvantage of Using Absorption Vs. Variable Costing. Chron. Small Business by Demand Media. Retrieved from http://smallbusiness.chron.com/advantages-disadvantages-using-absorption-vs-variable-costing-34282.html
Geri Wink. (2010). Income Inflation: Absorption Costing vs. Variable. Journal of the International Academy for case Studies. Retrieved form http://search.proquest.com.proxy.davenport.edu/docview/845495937?pq-origsite=summon