Absorption costing includes all costs, including fixed costs, in figuring the cost of production, while variable costing only includes the variable costs directly related to production. Companies that use variable costing keep overhead and other fixed-cost operating expenses separate from production costs.
The fixed costs that differentiate variable and absorption costing are those overhead expenses, such as salaries and building rental, that do not change with changes in production levels. A company has to pay its office rent and utility bills every month regardless of whether it produces 1,000 products or no products at all.
Whichever costing method a company selects to use for accounting purposes, there are advantages and disadvantages. Variable costing can make it more difficult to determine ideal pricing, since it does not directly consider all of the costs the company has to cover to be profitable. However, by looking only at the costs directly associated with production, variable costing makes it easier for a company to compare the potential profitability of manufacturing one product over another.
One of the advantages of absorption costing is that it is the costing method required for a company to be in compliance with generally accepted accounting principles (GAAP). Even if a company decides to use variable costing in-house, it is required by law to use absorption costing in any external financial statements it publishes. Absorption costing is also the costing method that a company is required to use for calculating and filing its taxes.
Absorption costing provides a more accurate accounting of net profitability, especially when a company doesn’t sell all of its products in the same accounting period when they are manufactured. Absorption costing is not as helpful as variable costing for comparing profitability of different product lines.
Variable costing enables a company to run cost-volume profit analysis, which is designed to reveal the company’s break-even point in production by determining how many products a company must manufacture and sell to reach the point of profitability.