Absorption costing
System used in valuing inventory
Formula of Absorption costing
Cost of Materials & Labour + Variable & Fixed MOH
Gross Profit Calc. format
Components of Absorption costing
- Direct material
- Direct labour
- Fixed & Variable MOH
FC part of Inventory via Allocated Budgeted Fixed MOH rate
Advantages of Absorption costing
- Takes all costs of production into account
- Takes DM & DL as well as IM & IL into account
Disadvantages of Absorption costing
- Not useful for the product decision making
- Provides a poor valuation of the actual cost of manufacturing a product
Direct/Variable costing
Costing method that ONLY includes DM, DL & Variable MOH in Production Cost
Contribution Calc. format
Components of Direct costing
- Direct material
- Direct labour
- Variable MOH
FC expensed in Total
Advantages of Direct costing
- Provides a better understanding of the effect of Fixed Cost on net profits
- Total Fixed Cost is shown on the Income Statement
Disadvantages of Direct costing
- Doesn’t assign FC to units of product
- Production costs can’t be truly matched with revenues
Variable & Fixed selling and admin cost
- Under absoprtion costing leads to period costs that don’t go into cost of product
- EXPENSED in period occurred
Absorption Costing in short
- Is the Gross Profit Calc format
- FC forms part of Inventory via Allocated Fixed MOH rate
- FC included in the Opening- & Closing balance on a per unit basis
Direct Costing in short
- Uses Contribution Calc format
- Fixed Costs are expensed in the Total
- Move Indirect Variable Costs “up” into the top section as part of contribution approach
Costs of Variable Costing
VC directly incurred in the production
Costs of Absorption Costing
Both Variable Costs & Fixed Costs are related to the production
Internal/External use of Variable Costing
Used for internal reporting purposes
Internal/External use of Absorption Costing
Used for reporting to external stakeholders as well as for the purpose of filing taxes
Relevance of Variable Costing
Used for comparing the profitability of different product lines
Relevance of Absorption Costing
Used for Calculation of per unit based on all the costs (including Fixed OH)
Reporting of Variable Costing
Based on internal specifications of reporting & presentation
Reporting of Absorption Costing
Based on external reporting standards given by external agencies
Inventory of Variable Costing
ONLY Variable Costs of production to be assigned to Inventory, WIP & CoGS
Inventory of Absorption Costing
Considering ALL PC and including them in Inventory & WIP
Contribution of Variable Costing
Sales - VC
Contribution of Absorption Costing
Calc. Net Profit
