If your small business is a manufacturing company, you have the choice of using absorption costing or variable costing in determining your profits. You must learn the implications of each before making this choice. While either method of accounting for costs is valid under generally accepted accounting principles, the method you choose can affect your profit-reporting.
Fixed Overhead Costs
You must understand fixed overhead expenses in order to understand absorption costing and variable costing. Fixed overhead consists of expenses that do not change with your level of production. Examples of fixed overhead include rent, insurance, wages for permanent full-time employees, and lease payments on equipment. These expenses continue no matter what your level of sales or how much you manufacture.
Absorption costing is a method whereby you apply part of your fixed overhead costs to the cost of manufacturing products. You do this on a per-unit basis. Simply divide your fixed costs by the number of units you manufactured and sold during the period. The result is a cost per unit for each unit you made and sold.
Variable costing uses fixed overhead as a lump sum, rather than a per-unit, expense. Under this method, you include all your variable costs such as supplies, raw materials and shipping. You add the full cost of fixed overhead for the period. You do not figure these expenses on a per-unit basis. Instead you subtract them from your revenue figure as a lump-sum expense.
Advantages of Absorption Costing
Absorption costing offers an advantage when you do not sell all of your manufactured products during the accounting period. You may have finished goods in inventory. Because you assign a per-unit amount for fixed expenses, each product in inventory has a value that includes part of the fixed overhead. You do not show the expense until you actually sell the items in inventory. This can improve your profits for the period.
Disadvantages of Absorption Costing
Absorption costing can artificially inflate your profit figures in any given accounting period. Because you will not deduct all of your fixed overhead if you haven't sold all of your manufactured products, your profit-and-loss statement does not show the full expenses you had for the period. This can mislead you when you are analyzing your profitability.
Advantages of Variable Costing
Variable costing shows your profits after all the bills have been paid for the accounting period. Though you may not have received revenues for the products you manufactured because some could be in inventory, you show that you have paid all of your expenses for the period. When you finally sell the finished products in inventory, you have surplus income.
Disadvantages of Variable Costing
Variable costing shows full payment for fixed-overhead expenses for the accounting period. Even if you don’t sell all the products you make, you must deduct the full cost of fixed overhead. This means you show less profit for the period because you show your complete overhead expense even when you haven’t sold all of your products. You show reduced income because of unsold products but full expenses for overhead.
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