Advantages of Variable or Direct or Marginal Costing System:
Learning Objectives:
- What are the advantages of variable
costing system?
- Why absorption costing continues to
be used almost exclusively for external reporting purposes?
Variable costing
has the following main advantages:
-
The data that are required for
cost volume profit (CVP) analysis can be taken directly from a
variable costing format income statement. These data are not available on a
conventional income statement based on
absorption costing.
-
Under variable costing, the profit for a period is not affected by changes
in inventories. Other things remaining the same (i.e. selling prices, costs,
sales mix, etc.), profits move in the same direction as sales when variable
costing is in use.
-
Managers often assume that unit product costs are variable costs. This is
a problem under absorption costing, since unit product costs are a combination
of both fixed and variable costs. Under variable costing, unit product costs
do not contain
fixed costs.
-
The impact of fixed costs on profits is emphasized under the variable
costing and contribution approach. The total amount of fixed costs appears
explicitly on the income statement. Under absorption, the fixed costs are
mingled together with the
variable costs and are buried in cost of goods sold
and in ending inventories.
-
Variable costing data make it easier to estimate the profitability of
products, customers, and other
segments of the business. With absorption
costing, profitability is obscured by arbitrary allocations of fixed costs.
-
Variable costing ties in with cost control methods such as standard costs
and flexible budgets.
-
Variable costing
net operating income is closer to net cash flow than
absorption costing net operating income. This is particularly important for
companies having cash flow problems.
With all of these advantages one might wonder why
absorption costing
continues to be used almost exclusively for external reporting purposes and why
it is predominant choice for internal reports as well. This is partly due to
tradition, but
absorption costing is also attractive to many accountants because
they believe it better matches costs with revenues. Advocates of
absorption costing argue that all manufacturing costs must be assigned to products in order
to properly match the costs of producing units of product with the revenues from
the units when they are sold. The
fixed costs of depreciation, taxes, insurance,
supervisory, salaries, and so on, are just as essential to manufacturing
products as are the
variable costs. Advocates of
variable costing argue that
fixed manufacturing costs are not really the costs of any particular unit of
product. These costs are incurred to have the capacity to make products during a
particular period and will be incurred even if nothing is made during the
period. Moreover, whether a unit is made or not, the fixed manufacturing cost
will be exactly the same. Therefore,
variable costing advocates argue that fixed
manufacturing costs are not part of the costs of producing a particular unit of
product and thus the matching principle dictates that fixed manufacturing costs
should be charged to the current period. At any rate,
absorption costing is the
generally accepted method for preparing mandatory external financial reports and
income tax returns. Probably because of the cost and possible confusion of
maintaining two separate costing systems-one for external reporting and one for
internal reporting-most companies use
absorption costing for both external and
internal reports. |
