Question

Why companies use the variable costing method when the absorption costing is the method approved by the General Accepted Accounting Principals. Provide at least 3 reasons that support the utilization the variable costing method.

Answer 1

1. Variable costing uses contribution margin format that highlights the distinction fixed and variable costs

2. Variable costing makes internal decision making too easy and is required for CVP analysis

3. It allow managers less latitude in selecting what to produce.

General explanation

Absorption costing system includes both variable and fixed manufacturing costs in the inventory. Variable costing includes only the variable manufacturing costs in the inventory and excludes fixed manufacturing costs. variable costing expenses fixed manufacturing costs in the period incurred.

If bonuses and other incentives are tied to operating income, managers might increase inventory even if no additional demand exists under absorption costing. It allows managers to manipulate operating income simply by increasing production. Managers might choose to produce items that absorb the highest fixed manufacturing costs instead that absorb less. To fix this and other improper management incentives, the company could switch to variable costing for internal reporting.

Performance evaluation and internal decisions are mostly based on controllable costs. Since fixed manufacturing costs are beyond the control of the managers, it is not a good idea to evaluate the performance of a manager using absorption costing. If more units are produced than sold absorption costing will have higher net income because the fixed costs are still in the inventory. Variable costing will have lower net income because the fixed costs are not in the inventory, but expensed.