Variable and absorption costing are two allocation methods that companies use to determine product cost. Each has significant differences in how they allocate manufacturing overhead. Variable costing only applies the variable manufacturing overhead costs. Absorption costing applies all manufacturing overhead costs, both fixed and variable. Direct material and direct labor allocation is the same for both methods; differences occur in income reporting, product pricing, and decision making.
Both of these costing methods fall under accrual accounting procedures. All costs get recorded as a company incurs them, regardless if cash changes hands or not. Fixed costs do not change in a production system regardless of output. Variable costing requires companies to expense fixed costs in the accounting period when they occur. The absorption method, however, adds fixed costs to the production system, ultimately allocating the costs to manufactured products.
Income reporting is one major difference between these two costing methods. Under the process described earlier, variable costing reports lower net income. This occurs because companies expense fixed costs, while absorption costing does not. Lower profit on the income statement reduces taxes paid by the company. Companies using the absorption method will not incur lower net income until they sell goods, which move the costs from inventory to cost of goods sold.
Product cost information is another significant difference. The variable method has a tendency to undercost manufactured goods because a company does not record fixed manufacturing overhead to products. Absorption cost principles seek a more defined product cost. Including all manufacturing overhead — fixed and variable — gives companies a more accurate description of costs needed to produce goods.
Another different is in pricing products. Companies that use variable costing may think they can price products lower than those using the absorption method, but this is untrue. Reducing the final selling price will result in lower net income because fixed manufacturing overhead resides as a period cost on the income statement. Companies need to ensure that they price goods appropriately to cover all product costs, whether on the income statement or included as the inventory cost.
Managerial decisions may also be different under each method. One issue, for example, is to select which method provides the most accurate product cost and meets accounting guidelines. National accounting standards may not approve of variable costing. Therefore, managers must determine which method their company should use. Another decision is how production output affects fixed costs, which can change on a per-unit basis when manufacturing goods.