There are two different approaches, as discussed below, for determining the cost of goods sold in a manufacturing concern.
Under the traditional method of accounting all the costs incurred in manufacturing, irrespective of their behavior with respect to volume, are regarded as product costs and included in the cost of the manufactured product. This method is referred to as absorption costing or full costing because the product absorbs the full amount of manufacturing costs.
Non-manufacturing costs (distribution costs, research and development costs, financial costs, and administrative costs) are regarded as period costs, to be expensed in the assuming period in which they are incurred or to the amortized over several accounting periods. The flow of costs under absorption costing is shown in the following image. Product costs, also known as inventoriable costs, are treated as assets until the product is sold, when they are matched against revenues.
Direct costing, also referred to as variable costing or marginal costing, has received a great deal of attention in the past few decades. Under this system, manufacturing costs are segregated between those which vary directly with volume and those which are fixed.
Only the variable costs (direct material direct labour, and variable manufacturing overhead costs) are used for valuing inventories and determining the cost of goods sold. The remaining manufacturing expenses are treated as period costs. The flow of costs under direct costing is shown in the following image.