Two accountants, two different prices for the same product
Take any product made by a small manufacturer: it involves raw materials and direct labor on the production line, but also factory rent, electricity for the entire facility, and the supervisor’s salary. Ask two accountants to calculate the product’s unit cost and selling price. If one uses absorption costing and the other variable costing, they will arrive at different figures—and not because of a calculation error. It comes down to the method.
Choosing between these two costing methods may seem like a technical accounting issue, far removed from the practical question of how much to charge. It isn't. The way costs are calculated determines how much room the margin has to account for factors beyond cost itself—and that is where most small businesses lose control of pricing without realizing it.
It is worth understanding the difference between the two before discussing why it matters so much when setting prices.
How Each Method Handles Fixed Costs
The difference between absorption and variable costing does not lie in direct costs—raw materials and direct labor are treated the same under both methods, in proportion to production volume. The difference lies in how fixed costs are treated: rent, machinery depreciation, supervisors’ salaries, and energy costs for the factory as a whole.
Absorption costing allocates all production costs—fixed and variable—across the products manufactured during the period. The facility's rent becomes part of each unit's cost, allocated according to a given criterion: production volume, labor hours, or raw material consumption. This allocation method is the only one accepted for tax purposes and external audits in Brazil: companies do not choose whether to use absorption costing in their official financial statements; the law has already made that decision for them.
Variable costing assigns only costs that vary with production to the product. Fixed costs are not allocated: they are treated as period expenses and charged in full against earnings, regardless of how many units leave the factory. The product’s unit cost includes only the resources actually consumed to produce it.
The practical impact is straightforward. Under absorption costing, unit cost changes with the total volume produced during the period—producing more spreads fixed costs across more units, while producing less concentrates the same fixed costs across fewer units. Under variable costing, unit cost does not change with volume: it reflects only the variable inputs consumed by that unit.
Why This Changes Pricing, Not Just Accounting Reports
This is where accounting and pricing diverge: when the formula is "cost plus margin," the type of cost included in the calculation determines how much flexibility there is to adjust the margin.
Using total cost—absorption cost, with fixed costs already allocated—confines the margin to a narrow range. The logic seems sound: cover everything, including the allocated share of rent and depreciation, then add a margin on top. But this cost already incorporates an arbitrary decision—the allocation method—and leaves little room for the margin to reflect anything beyond “covering the shortfall.” The most common result is a single margin: the same percentage for different products, because the allocation has already “justified” the price before any market analysis.
Using variable cost opens up another path. Because fixed costs are excluded from the product calculation, what remains from the sale after variable costs and expenses are deducted—the contribution margin—becomes product-specific information rather than a factory-wide average. This margin allows a high-volume product with a low percentage margin to coexist in the same product line with a niche product that supports a much higher margin. Instead of being a fixed figure, it becomes the link between the cost of that item and what the market is willing to pay for it.
Absorption costing is not wrong—it is required for financial statements, income tax, and audits. The mistake is using allocated cost alone as the basis for every commercial decision without calculating the contribution margin for each product.
An Example with Numbers
A small factory makes a product with a variable cost (raw materials and direct labor) of R$ 40 per unit. The factory’s monthly fixed costs—rent, utilities, and supervision—total R$ 8,000, and its normal production volume is 400 units per month.
Under absorption costing, the allocated fixed cost per unit is R$ 8,000 ÷ 400 = R$ 20. The total unit cost rises to R$ 60 (R$ 40 in variable costs + R$ 20 in allocated fixed costs). Applying a 35% markup to this total cost:
price = cost × (1 + markup) = 60 × 1.35 = R$81.00
If production volume drops to 200 units in a slow month, the same R$ 8,000 fixed cost is spread across fewer units: R$ 40 allocated per unit, bringing the total cost to R$ 80. Applying the same 35% markup would push the price to R$ 108—a cost increase that has nothing to do with what customers are willing to pay and everything to do with that month’s lower production volume.
Under variable costing, the product cost remains R$ 40, whether the factory is running at full capacity or not. At a selling price of R$ 81, the contribution margin per unit would be R$ 41 (R$ 81 − R$ 40). Across all units sold, that margin must cover the R$ 8,000 in fixed costs and still leave a profit. Dividing R$ 8,000 by the R$ 41 contribution margin puts this product’s accounting break-even point at around 195 units. Absorption costing does not provide this figure on its own because it combines fixed and variable costs in the unit cost. To run this calculation with other figures, the markup calculator gives you the answer instantly.
What the Two Methods Reveal—and What They Hide
Neither method is universally “right”—each one answers a different question:
- Absorption costing answers “how much did it cost to produce all of this, and what was the accounting profit for the period?”—the question addressed by the balance sheet and income tax return.
- Variable costing answers “how much each product contributes toward covering fixed costs and generating profit” — the question for anyone making decisions about pricing, product mix, and even whether to accept an order below the list price when there is idle capacity.
This second question is the one small businesses most often fail to answer. A manufacturer may have flawless tax accounting, with absorption costing calculated correctly for audit purposes, yet still not know the contribution margin of each product. Break-even analysis, cost-volume-profit analysis, and decisions about how much to discount a specific product all depend on variable costing—not because the other method is wrong, but because it was not designed to answer this question.
It also helps to review how profit margin is calculated for each product — see our guide to calculating profit margin in retail.
Putting Both Perspectives to Work Together
In practice, the answer isn't to choose one method and discard the other—it's to use each one where it works best:
- Keep absorption costing for official financial statements, as required by law and auditing standards.
- Calculate the contribution margin for each product using variable costing, clearly separating fixed and variable costs for each product line.
- Set prices based on each item's contribution margin, rather than applying a single margin to costs allocated across the entire factory.
- Use the break-even point for each product to determine how much each item needs to sell each month, rather than treating the entire catalog as if every product had the same margin for error.
- Periodically review the allocation method used in absorption costing, because a poorly chosen method can distort unit costs without anyone realizing the cause.
The difference between the two methods is not an academic accounting debate. It is the difference between a price that responds to last month's production volume and one that reflects the profit each product generates. If you only look at absorption costing, you get the right picture for tax purposes but the wrong one for deciding what to charge tomorrow.
