Variable and Absorption Costing

I am writing this memorandum with reference to our discussion about your plan to start a garment
manufacturing business. Before giving advice on this matter I would first like to briefly explain to you
both the variable and absorption costing methods, their differences and benefits, so as to enable you to
take an informed decision in the matter.

The Variable Costing and absorption costing are different methods for allocating manufacturing coating
direct and indirect manufacturing cost to goods and services produced. Under the variable costing
Method, all the variable cost relating to raw material, labor, Variable manufacturing, selling, general and
administrative expenses are deducted from total sale in order to arrive at contribution margin. All FIxed
Overhead expenses are expensed as period cost and the value of the closing inventory does not include
any fixed manufacturing overhead. Due to these reasons, the variable costing method is also called as
direct costing method. Unlike the variable costing method, under the absorption costing the portion of
fixed and variable manufacturing expenses relating to goods sold during the year are expensed and
those related to unsold goods are capitalized as inventory. Due to this reason it is called the full costing
method. There is a difference in the amount of net profit calculated under both the methods due to the
manner in which the fixed manufacturing overhead are treated.

Variable costing method will enable the firm to calculate the contribution margin, effect of change in
sales volume on the contribution margin and it will help firm in taking important cost, volume and
pricing decisions. Due to this reason it is said that variable costing is suitable for internal reporting and
management decision making purposes. During the initial he years the fixed cost element of the firm will
be high. under the variable costing method, the entire fixed cost element is expensed during the year
due to which profitabilty reflected under the financial statement will be low and they even reflect a loss,
As compared to this, if the absorption costing method is used the element of fixed cost related to ending
inventory is capitalized due to which the profit will be comparatively higher. Thus absorption costing is
much more suitable for external reporting purpose. Lower profit margin or booking losses in the initial
tears may have a diminishing effect on the investors of the firm and thereby hinder the borrowing
capacity of the firm. Most importantly the absorption costing method is an accepted method under US
GAAP, whereas the variable costing method is not allowed for externhe reporting purpose.

The best part is variable and absorption costing methods are complimentary to each other. Thus i would
like to advise you to use the variable costing method for internal reporting and descion making purpose
whereas to use absorption costing system for external reporting purpose.