Costing and Evaluation of Costs

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How does absorption costing differ from variable costing? Why does it matter?
ABSORPTION COSTING:
In product/service costing, an absorption costing system apportions a share of all costs incurred by a business to each of its products/services. In this way, it can be established whether, in the long run, each product/service makes a profit. Thus under absorption costing, all normal manufacturing costs are considered product costs and included in inventory. As sales occur, the cost of inventory is transferred to cost of goods sold; meaning that the gross profit (sales minus cost of goods sold) is reduced by all costs of manufacturing, whether those costs relate to direct materials, direct labor, variable manufacturing overhead, or fixed manufacturing overhead.

Using an absorption costing system, the profit reported for a manufacturing business for a period will be influenced by the level of production as well as by the level of sales. This is because of the absorption of fixed manufacturing overheads into the value of work-in-progress and finished goods stocks. If stocks remain at the end of an accounting period, then the fixed manufacturing overhead costs included within the stock valuation will be transferred to the following period.

VARIABLE COSTING:
Here the focus is on separating costs into variable elements and fixed elements. Here only variable production costs are assigned to inventory and cost of goods sold. These costs generally consist of direct materials, direct labor, and variable manufacturing overhead. Fixed manufacturing costs are regarded as period expenses along with administration costs.
It can be very useful for short-term planning, control and decision-making, especially in a multi-product business.
Thus, sales less variable costs (regardless of function) measures the contribution that individual products/services make towards the total fixed costs incurred by the business. The fixed costs ...