On the basis of behavior, cost can be classified as Fixed
cost and variable cost.
 Fixed cost remain constant in aggregate amount and do not
vary with the increase or decrease in production up to a given
level of output.
Aggregate Variable cost varies to increase or decrease in
level of output and remain constant per unit of output.
 Thus, fixed overheads leads to different cost per unit at
different level of output.
 on account of this , a special technique is used called Direct
costing or Marginal Costing which excludes fixed overheads
entirely from the cost of production and gives us same cost
per unit up to a particular level of output

Direct costing is a costing system under which those costs
of production that vary with output are treated as product
costs. This would usually include direct materials, direct labor
and variable portion of manufacturing overhead.
Fixed manufacturing cost is not treated as a product costs
under variable costing. Rather, fixed manufacturing cost is
treated as a period cost and, like selling and administrative
expenses, it is charged off in its entirety against revenue each
The cost of a unit of product in inventory or cost of goods
sold under this method does not contain any fixed overhead
Variable costing is some time referred to as direct costing or
marginal costing.

Advantages of Variable or Direct or
Marginal Costing System:

The data that are required for cost volume profit (CVP)
analysis can be taken directly from a variable costing format
income statement. These data are not available on a
conventional income statement based on absorption costing.
 The valuation of closing stock under direct costing is done at
marginal cost and thus prevents the illogical carry forward of
fixed costs of one period to next period as part of value of stock
 There is no problem of computing fixed overhead recovery
rates and their over or under recovery as fixed overheads are
charged against contribution.
Sales- variable cost = Contribution.
 It establishes that profit is function of sale and not of
production as profit depends on sales volume and not on
production volume.
 It facilitates control over variable cost by avoiding
apportionment and allocation of fixed costs

The impact of fixed costs on profits is emphasized under
the variable costing and contribution approach. The total
amount of fixed costs appears explicitly on the income
statement. Under absorption, the fixed costs are mingled
together with the variable costs and are buried in cost of
goods sold and in ending inventories.
Variable costing ties in with cost control methods such as
standard costs and flexible budgets.
 It is very useful tool for profit planning.
It is valuable technique in decision making
 It provides the management with useful technique like BE
analysis, P.V ratio etc
It helps management in cost control by concentrating on
variable cost as fixed cost is uncontrollable in short run.


Absorption costing is required for external reports in
United States and almost all over the world. A company
that attempts to use variable costing (also called direct costing
and marginal costing) on its external financial reports runs the
risk that its auditors may not accepts the financial statements
as conforming to generally accepted accounting principles
Tax laws almost all over the world require the usage of a
form of absorption costing for filling out income tax
 The separation of expense as fixed and variable present
technical difficulties.
 With development of technology, fixed expenses have
increases and their impact on production is much more than
variable cost. Ignoring fixed expenses makes costing system
less effective.

 It cannot be successfully applied in cost plus contract
unless a high percentage over marginal cost is charged from
contractee to cover fixed cost and profit.

Further Discussion on Direct Costing
 A direct cost is a cost that is directly associated
with changes in production volume. This usually
restricts the definition of direct costs to direct
materials and direct labor (and a strong case can
be made for NOT using direct labor, since this
costs tends to be present even when production
volumes vary). For example, the materials used
to create a product are a direct cost, whereas the
machine used to convert the materials into a
finished product is not a direct cost, because it is
still going to be sitting on the factory floor,
irrespective of any changes in production volume.
Further Discussion on Direct Costing
 By focusing solely on the direct cost of a product
or activity, a cost accountant can provide valuable
information to management regarding prospective
changes in costs that will arise as a result of
some management action. For example, if a
change to a more efficient type of processing
equipment is contemplated, then the direct cost of
a product may be lowered if this will result in less
material usage. This may also result in less direct
labor cost if the machine takes over some tasks
previously performed by employees - this will cut
direct costs, but may increase overhead costs if
the cost of the machine is higher than that of the
machine that it is replacing.
Further Discussion on Direct Costing
 Yet another example is when a customer wants
the lowest possible price for a product, and the
company has some free capacity available for
producing what the customer needs; the use of
direct costing will reveal the lowest possible cost
that must be covered by the price charged to the
customer in order to break even. Direct costing
can also be used to determine which customers
are the most profitable, by subtracting the direct
cost of their purchases from the prices paid,
which yields the amount they are contributing
toward the company's coverage of overhead
costs and profit.
Further Discussion on Direct Costing
 Another very good use for direct costing is to
include the concept in the budgeting system,
where it is used to change budgeted variable
costs to match the actual sales volumes
achieved; this approach achieves a much closer
match between the budgeted and actual cost of
goods sold, because the budget now flexes with
the actual volume level experienced. For all of
these reasons, direct costing is a highly
recommended costing system.
Further Discussion on Direct Costing
 However, there are a number of situations in
which direct costing should not be used, and in
which it will yield incorrect information. Its single
largest problem is that it completely ignores all
indirect costs, which make up the bulk of all costs
incurred by today's companies. This is a real
problem when dealing with long-term costing and
pricing decisions, since direct costing will likely
yield results that do not achieve long-term
Further Discussion on Direct Costing
 For example, a direct costing system may
calculate a minimum product price of $10.00 for a
widget that is indeed higher than all direct costs,
but which is lower than the additional overhead
costs that are associated with the product line. If
the company continues to use the $10.00 price
for all product sales for well into the future, then
the company will experience losses because
overhead costs are not being covered by the
 The best way to address this problem is to build
strict boundaries around the circumstances where
incremental prices derived from a direct costing
system are used.
Further Discussion on Direct Costing
 Another problem with direct costing is that it
assumes a steady level of unit costs for the
incremental costing and pricing decisions for
which it is most often used. For example, a
company receives an offer from a customer to
buy 5,000 units of Product ABC at a fixed price.
The cost accounting staff may determine that the
proposed price will indeed yield a profit, based on
the direct cost per unit, and so recommends that
the deal be approved..
Further Discussion on Direct Costing
 However, because the staff has only focused on
direct costs, it has missed the fact that the
company is operating at near full-capacity levels,
and that to process the entire 5,000-unit order will
require the addition of some costly machinery, the
acquisition of which will make the proposed deal
a very expensive one indeed. To avoid this
problem, anyone using a direct costing system
must have access to company capacity
information, and should coordinate with the
production scheduling staff to ensure that
capacity levels will permit their incremental pricing
and costing scenarios to be achieved
Further Discussion on Direct Costing
 Direct costing cannot be used for inventory
valuation, because it is disallowed by GAAP. The
reason for this is that, under a direct costing
system, all costs besides direct costs are charged
to the current period. There is no provision for
capitalizing overhead costs and associating them
with inventory that will be sold off in future
periods. This results in an imbalance between the
reported level of profitability in each period and
the amount of production that occurred.
Further Discussion on Direct Costing
 For example, a manufacturer of Christmas
ornaments with a direct costing system may sell
all of its output in one month of the year, but be
forced to recognize all of its non-direct production
costs in every month of the year, which will result
in reported losses for eleven months of the year.
Under GAAP, these non-direct costs would be
capitalized into inventory and recognized only
when the inventory is sold, thereby more closely
matching reported revenues and expenses.
Given the wide disparity between the reported
results, it is no surprise that GAAP bans the use
of direct costing for inventory valuation.

Absorption costing is a costing system which treats all
costs of production as product costs, regardless weather they
are variable or fixed.
The cost of a unit of product under absorption costing
method consists of direct materials, direct labor and both
variable and fixed overhead.
Absorption costing allocates a portion of fixed
manufacturing overhead cost to each unit of product, along
with the variable manufacturing cost.
Because absorption costing includes all costs of production
as product costs it is frequently referred to as full costing
we need to consider briefly the handling of selling and
administrative expenses. These expenses are never treated
as product costs, regardless of the costing method in use.
Thus under either absorption or variable costing, both
variable and fixed selling and administrative expenses are
always treated as period costs and deducted from revenues
as incurred
Recognizes the importance of including fixed
manufacturing cost in product cost determination and
framing a suitable pricing policy.
Show correct profit calculations in case where
production is done to have sales in future( e.g seasonal
sales) as compared to variable costing
Helps to conform with accrual and matching concept
which require matching cost with revenue for particular
 Recognized by various bodies as FASB( USA), ASC(UK),
ASB(India) for purpose of preparing external reports and
valuation of inventory.
 Avoids separation of cost into fixed and variable elements
which cannot be done easily and accurately
 Discloses inefficient or efficient utilization of production
resources by indicating under-absorption or over-absorption
of overheads.
Helps to calculate gross profit and net profit separately in
income statement.

 Difficulty in comparison and control of cost.- An
increase in volume of output result in decrease in unit cost
and decrease in volume of output result in increases in unit
 Not helpful in managerial decision- selection of suitable
product mix, weather to buy or manufacture, choice of
alternatives etc.
 Cost vitiated because of fixed cost included in
inventory valuation.- As closing stock is valued at cost of
product ion.
 Fixed cost inclusion in cost not justified
 Apportionment of fixed overheads by arbitrary method
 Not helpful for preparation of flexible budgets.
Number of units produced 6,000
Variable costs per unit:
Direct materials $2
Direct labor $4
Variable manufacturing overhead $1
Variable selling and Administrative expenses $3
Fixed costs per year:
Fixed manufacturing overhead $30,000
Fixed selling and administrative expenses $10,000
To illustrate the computation/calculation of unit product costs
under both absorption and variable costing consider the
following example.
A small company that produces a single product has the
following cost structure.


Unit product Cost
Absorption Costing Method
Direct materials $2
Direct labor $4
Variable manufacturing overhead $1
Total variable production cost $7
Fixed manufacturing overhead $5
Unit product cost $12
Unit product Cost
Variable Costing Method
Direct materials $2
Direct labor $4
Variable manufacturing overhead $1
Unit product cost $7
“ why absorption costing continues to be used
almost exclusively for external reporting
purposes and why it is predominant choice for
internal reports as well”.

This is partly due to tradition, but absorption costing is
also attractive to many accountants because they believe it
better matches costs with revenues.
Advocates of absorption costing argue that all
manufacturing costs must be assigned to products in order
to properly match the costs of producing units of product
with the revenues from the units when they are sold.
 The fixed costs of depreciation, taxes, insurance,
supervisory, salaries, and so on, are just as essential to
manufacturing products as are the variable costs