The absorption approach and the contribution approach are two different methods of calculating the profitability of a product or service.
The absorption approach, also known as full costing, takes into account all the direct and indirect costs associated with producing a product or service. These costs include both variable and fixed costs such as raw materials, labor, manufacturing overhead, and administrative expenses. In the absorption approach, these costs are absorbed into the cost of the product or service, resulting in a higher cost per unit. This approach is commonly used for external reporting and is required by Generally Accepted Accounting Principles (GAAP) in some countries.
On the other hand, the contribution approach, also known as direct costing, only takes into account the direct costs of producing a product or service. This includes only the variable costs such as raw materials, labor, and any other direct costs that can be directly attributed to the production of the product or service. Fixed costs such as rent, utilities, and administrative expenses are not included in the calculation. The contribution approach is commonly used for internal decision making and is particularly useful for determining the profitability of different products or services within a company.
In summary, the absorption approach includes all costs, both fixed and variable, while the contribution approach only includes the variable costs. The choice between the two approaches depends on the purpose of the analysis and the level of detail required.