What are the benefits of absorption costing versus variable costing?

Variable costs increase as the output increases. For eg: To produce a pen you need Ink of ?1, other material of ?2, Electricity of ?1, Labour of ?1. Hence VC to produce a pen = ?5. If you produce 10 pens the VC would be ?50. If you produce 10k pens the VC would be ?50k. Direct Costs can be directly attributable to the output (eg. Ink) Indirect Costs can't be directly attributed to the output (eg. Rent) Fixed costs occur irrespective of any activities conducted. For eg- Your factory rent is ?10k. It won't matter if you produce 10k pens or 10 Lakh pens- Rent will be ?10k only. Absorption costing values stock at Full cost of production i.e. Fixed + Variable. So,if you produce 10k pens, the Cost would be 5+1 = ?6 under absorption costing.

Absorption costing includes all cost with direct cost but in variable costing some of direct is no included. Variable costing is more useful than absorption costing if a company wishes to compare different product lines' potential profitability. It is easier to discern the differences in profits from producing one item over another by looking solely at the variable costs directly related to production

Variable costing is a very powerful tool in certain decision making situations. In periods when there is excess capacity a variable costing approach gives a clearer picture of what an optimal decision should be. Make or buy decisions are a good fit for a variable costing approach. Variable costing approach to decision making mostly provides logical solution to a complex problem.

Under Variable Costing method, stock is valued at Variable cost of production and Fixed costs are treated as Period Costs. For e.g. - If you produce 5k pens with Variable cost per unit ?5 and your fixed cost for that period is ?10k rent. Assume all the inventory is unsold. Under Variable Costing method, the stock will be valued at ?25k (5k pens * ?5 VCPU), ?10k rent will be Expensed out in P&L. Hence Total Cost per Unit as per Variable Costing = ?5 Under Absorption costing the stock will be valued at ?35k (5k pens * ?5 VCPU) + (5k pens * ?2 FCPU) ?2 FCPU = Rent of ?10k / 5k pens. Hence Total Cost per Unit under Absorption Costing = ?7

To comply with GAAP, one needs to follow absorption costing as it shows True cost of Production. For eg- If You Produce 10k units with Total Variable Cost of ?10k and you incurred Fixed cost of ?10k. (VCPU ?1, FCPU ?1) You made a sale worth ?20k (sold 5k units & 5k are lying as inventory) (SPPU ?4) Now if you Follow Variable Costing stock will be valued at ?5k as against ?10k under Absorption costing. Profit under Variable Costing would be = ?5k (Sale ?20k + Cl Stock ?5k - Cost ?20k) Profit under Absorption Costing would be = ?10k ( Sale ?20k + Cl Stock ?10k - Cost ?20k) Following Absorption Costing leads to True & Fair Financial Statements that can aid investors and other stakeholders to make an informed decision.

Consider a furniture manufacturer that produces tables and chairs. The variable costs associated with producing a table include the costs of wood, labor, and paint. These costs are fixed for a given production run, but they vary depending on the number of tables produced. By carefully managing these costs, the manufacturer can set competitive prices and attract more customers. However, it's important to note that managing variable costs without considering absorption costs, which are fixed expenses allocated to inventory, can lead to misleading profit margins. For instance, if a company experiences a decrease in sales, its inventory levels may rise, inflating absorption costs and potentially masking the true profitability of the business.