What is the primary distinction between absorption costing and variable costing?

The primary distinction between absorption costing and variable costing lies in how they treat manufacturing costs in relation to product costs. Absorption costing encompasses all manufacturing costs, including both fixed and variable costs, thereby absorbing all costs associated with the production of a product into the cost of that product. This means that every unit of product manufactured includes a portion of both the variable costs (like raw materials and direct labor) and fixed costs (such as factory overhead).

In contrast, variable costing only accounts for variable manufacturing costs. Fixed manufacturing costs are treated as period costs and are expensed in the period incurred rather than being assigned to individual units of product. This fundamental difference leads to varying profit reporting between the two methods, particularly in situations of inventory production and sales.

Understanding this distinction is important for decision-making purposes, cost control, and inventory valuation, as the choice between absorption and variable costing can significantly impact financial statements and performance evaluation.