What are absorption, variable, and throughput costing approaches?

April 19, 2010

1. Absorption costing, variable costing, and throughput costing

There are three accounting approaches used to assign costs for income statement reporting purposes: absorption costing, variable costing, and throughput costing.  These methods are differently used for external and internal reporting purposes. In addition, these approaches differ in the way they treat product (inventory) and period costs.

2. Different costing approaches for external and internal reporting

External reporting: Absorption costing is used in preparing financial statements for external reporting purposes. US GAAP states that all product costs should be expensed as cost of goods sold and thus should be matched against revenues when products are sold. That is, product costs can be incurred in one (i.e. when goods are manufactured) and recognized in another period (i.e. when goods are sold). On other hand, period costs such as administrative and selling (i.e. SG&A) expenses are recognized when incurred because these costs have no future benefits.

Internal reporting: For internal reporting purposes, however, absorption, variable, or throughput costing approaches can be used. Absorption costing can be used to save additional costs of preparing reports since absorption costing must be used for external reporting purposes in any case. For short-term planning, however, it is more appropriate to use either variable or throughput costing approach because fixed costs do not change within a relevant range as a result of short-term decisions. In addition, throughput costing reduces the incentives for management to build up inventory to inappropriate levels because this method includes only direct materials cost into the inventory cost. As direct labor and factory overhead costs are treated as period costs under the throughput costing approach, managers tend to control these costs more carefully.

3. Treatment of inventory costs and period costs

Absorption costing: Under the absorption costing approach, products "consume" all manufacturing costs (both fixed and variable). That is, all manufacturing costs are expensed as inventory costs (Cost of Goods Sold). Administrative and selling costs (both fixed and variable) are expensed as period costs. Thus, absorption costing reflects the idea that product (i.e. manufacturing) and non-product (i.e. period) costs should be distinguished on the financial statements while it makes no distinction between fixed and variable costs.

Variable costing: On the other hand, under variable costing approach, product and period costs are divided into two groups: variable and fixed costs. Variable costing approach treats all variable costs as inventory costs and all fixed costs as period costs.

Throughput costing: Finally, under throughput costing, only direct materials are recorded as inventory costs while all other manufacturing costs (including direct labor and variable factory overhead) are expensed as period costs. Selling and administrative costs are expensed as period costs as well.

The comparison of the absorption, variable, and throughput costing methods is summarized in the table below:

 

Absorption Costing

Variable Costing

Throughput Costing

External Reporting

GAAP

Not GAAP

Not GAAP

Internal Reporting

Used to save costs

Used to evaluate performance and for decision making

Used for short-term capacity decisions

Inventory costs

Direct materials

Direct labor

Variable overhead

Fixed overhead

Direct materials

Direct labor

Variable overhead

Variable SG&A expenses*

Direct materials

Period costs (expensed when incurred)

SG&A expenses

Fixed overhead

Fixed SG&A expenses

Direct labor

Variable overhead

Fixed overhead

SG&A expenses

(*) Under the variable costing approach, variable SG&A expenses do not comprise inventory costs, but they are reported together with the inventory costs (Cost of Goods Sold) in the income statement; as the result, variable costs are reported separately from fixed costs.

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