Standard costing and absorption costing are two distinct methods used in cost accounting to determine the cost of a product or service. Understanding the differences between these two methods is crucial for organizations to accurately allocate costs, value inventory, and make informed decisions.
Definition
Standard Costing
Standard costing is a method of cost accounting that uses predetermined unit costs to value inventory. It involves establishing standard costs for direct materials, direct labor, and overhead costs based on historical data, industry benchmarks, or engineering estimates. These predetermined costs are then used to calculate the total cost of production.
Absorption Costing
Absorption costing is a method of cost accounting that assigns all manufacturing costs to inventory. This includes direct materials, direct labor, and all manufacturing overhead costs, both variable and fixed. The total manufacturing costs are then allocated to each unit of production based on a predetermined allocation rate.
Cost Allocation
Standard Costing
In standard costing, costs are allocated based on predetermined standards or benchmarks. These standards are established for each cost element, such as direct materials, direct labor, and overhead costs. Actual costs are then compared to these standards to identify variances.
Absorption Costing
In absorption costing, all manufacturing costs, including direct costs and fixed overhead costs, are allocated to inventory. The allocation of fixed overhead costs is typically based on a predetermined overhead rate, which is calculated by dividing the total estimated fixed overhead costs by the total number of units expected to be produced.
Treatment of Fixed Overhead Costs
Standard Costing
Fixed overhead costs are included in the predetermined standard cost but are not directly assigned to inventory. Instead, they are treated as a period cost and expensed in the period in which they are incurred.
Absorption Costing
Fixed overhead costs are allocated to inventory based on a predetermined rate. This rate is calculated by dividing the total estimated fixed overhead costs by the total number of units expected to be produced. The fixed overhead cost per unit is then added to the variable manufacturing costs to determine the total cost per unit.
Reporting Requirements
Standard Costing
Standard costing is commonly used for internal management purposes to analyze variances between actual and standard costs. It helps identify areas where costs are higher or lower than expected, enabling managers to take corrective actions and improve cost efficiency.
Absorption Costing
Absorption costing is required for external reporting under Generally Accepted Accounting Principles (GAAP). It provides a more comprehensive view of the cost of goods sold and ending inventory, which is essential for financial reporting and tax purposes.
Conclusion
Standard costing and absorption costing are two distinct methods of cost accounting with different approaches to cost allocation and treatment of fixed overhead costs. Standard costing is primarily used for internal management purposes to analyze cost variances, while absorption costing is required for external reporting under GAAP. Organizations should select the appropriate costing method based on their specific needs and reporting requirements.
References:
- Is Standard Costing the Same as Absorption Costing? – Accounting Professor
- Absorption Costing vs. Variable Costing: What’s the Difference? – Investopedia
- Absorption Costing – Investopedia
FAQs
What is the primary difference between standard costing and absorption costing?
The primary difference lies in the treatment of fixed overhead costs. Standard costing includes fixed overhead costs in the predetermined standard cost but does not directly assign them to inventory. Absorption costing, on the other hand, allocates fixed overhead costs to inventory based on a predetermined rate.
When is standard costing used?
Standard costing is primarily used for internal management purposes, such as analyzing cost variances, identifying areas of cost inefficiencies, and making informed decisions to improve cost control.
Why is absorption costing required?
Absorption costing is required for external reporting under Generally Accepted Accounting Principles (GAAP). It provides a more comprehensive view of the cost of goods sold and ending inventory, which is essential for financial reporting and tax purposes.
Which costing method is more accurate?
Both standard costing and absorption costing have their own advantages and disadvantages. Standard costing provides a more accurate picture of the actual cost of production, while absorption costing provides a more consistent picture of profitability from period to period. The choice of costing method depends on the organization’s specific needs and reporting requirements.
Can standard costing be used without absorption costing?
Yes, standard costing can be used without absorption costing. However, absorption costing is generally considered to provide a more accurate picture of the actual cost of production.
What are the advantages of using standard costing?
The advantages of using standard costing include:
- Improved cost control and efficiency
- Identification of cost variances
- Better decision-making
- Simplified inventory valuation
What are the disadvantages of using absorption costing?
The disadvantages of using absorption costing include:
- Potential for over or under-absorption of fixed overhead costs
- More complex inventory valuation
- Less accurate representation of the actual cost of production in certain situations
How do I choose the right costing method for my organization?
The choice of costing method depends on various factors, including the organization’s industry, size, and reporting requirements. It is important to carefully consider the advantages and disadvantages of each method and select the one that best aligns with the organization’s specific needs and objectives.