VARIABLE AND ABSORPTION COSTING

Variable and Absorption Costing is one of the topics which a managerial

executives should understand too. These costing approaches differ from
each other in the presentation of income, fixed cost and variable cost.
For internal purposes, the absorption cost approach helps a manager to
know the full cost of manufacturing cost while the variable cost approach do
not present the fixed manufacturing overhead cost.
Variable costing may provide a clearer picture of the actual incremental costs
associated with a specific product. Essentially, the variable costing method
can give producers and those concerned with financial records an accurate
representation of what actually goes into the costs of producing. Proponents
of variable costing argue that fixed manufacturing overhead costs are
incurred regardless of production volume and therefore should not be
considered in product-related decision-making. Therefore, variable costing
method users can enjoy a reported cost that is representative of the actual
inputs to the products. However, by ignoring fixed manufacturing overhead
costs, variable costing may understate a products overall cost. The
manufacturing overhead is important because, though the costs included in
overhead do not contribute directly to the creation of the product, there is

still some residual effect on the production which drives up the cost to
produce.
In contrast to the variable costing method, absorption costing may provide a
fuller picture of a products cost by including fixed manufacturing overhead
costs. A proponent of this method would argue that it is most effective
because, simply enough, all the possible costs are included. What this
method does is give a company or organization a more accurate view of the
products importance from an economic standpoint. If the product is turning
over a good amount of revenue in the absorption costing method, that
means that it is turning over revenue in addition to the unrelated costs of
production. However, absorption costing ignores the differential usage of
indirect resources across products or product lines. Also, absorption costing
can be used as an accounting trick to increase net income by moving fixed
manufacturing overhead costs from the income statement to the balance
sheet simply by increasing production volume disproportionately to sales
volume.
That is the reason why absorption costing is required for external reporting
by GAAP.