Question

What are the differences between variable and absorption costs? And how useful both of the cost information to management.

Answer 1

Difference between absorption costs and variable costs :

1) Absorption costs includes all costs, including fixed costs, related to production. But variable costs only includes variable costs directly related in production.

2) Absorption costs consists of direct materials costs, direct labor costs, variables manufacturing overhead , fixed manufacturing overhead. On the other hand variable costs consists direct materials costs, direct labor costs, variables manufacturing overhead .

3) Absorption costs are used for reporting to the external stakeholders as well as for tax filing . Variable costs are used for internal reporting purposes .

4) Absorption cost is used to calculate the net profit. On the other hand variable cost is used to calculate contributions. Contributions is the difference between sales and variable cost of sales.

How variable cost information is useful to the management ?

At the time of selection and determination of products which will be continued , management use variable costs of different products. Variable cost information is useful to conduct break even analysis , determine contribution margin and decision making excluding fixed manufacturing overhead . It is used for internal reporting purposes.

How absorption cost information is useful for the management ?

It identifies fixed costs related to the production. It is used for preparing final accounts as it compliance with GAAP. Net profit can be accurately calculated by having absorption costs because it considered variable as well as fixed costs related to the production. Management consider itself as full cost of the production. It is used for external reporting and tax filing purpose.