Advantages Disadvantages and Limitations of Variable Costing System:
Advantages of Variable/Direct/Marginal Costing System:
Following are the main advantages
of using variable costing system::
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
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
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 reporting 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.
Limitations of Variable Costing - GAAP
and External Reports:
Practically speaking, absorption costing is
required for external reports in United States and almost all over the world. A
company that attempts to use variable costing (also called direct costing
and marginal costing) on its external financial reports runs the
risk that its auditors may not accepts the financial statements as conforming to
generally accepted accounting principles (GAAP). Tax laws almost all over
the world require the usage of a form of absorption costing for filling out
income tax forms.
Even if a company must use absorption costing
for its external reports, a manager can use variable costing statements
for internal reports. No particular accounting problems are created by using
both costing methods--the variable costing method for internal reports and the
absorption costing method for external reports. The adjustment from variable
costing net operating income to absorption costing net operating income is a
simple one that can be easily made at year-end.
Top executives are typically evaluated based on
the earnings reported to shareholders on the external financial reports. This
creates a problem for top executives who might otherwise favor using variable
costing for internal reports. They may feel that since they are evaluated based
on absorption costing reports, decisions should also be based on absorption
Absorption Costing Around the World:
Absorption costing is norm around the
world for external financial reports. After the fall of communism,
accounting methods were changed in Russia to bring them into closer
agreement with accounting methods used in the west. One result was the
adoption of absorption costing