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::

1. 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.

2. 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.

3. 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.

4. 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.

5. 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.

6. Variable costing ties in with cost control methods such as standard costs and flexible budgets.

7. 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 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 costing data.

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