Many managers use variable costing for internal reporting and decision making since it has number of advantages (Myers par. 1). First, on variable costing reports costs are organized by behavior which makes it easier to understand. Also, variable costing statements facilitate cost volume profit (CVP) analysis because it separates cost behavior by fixed and variable. Under variable costing, changes in inventory or production do not affect the net operating income. In other words, income moves in the same direction as sales.
In addition, under absorption costing, managers are likely to misinterpret unit product costs as variable costs since they contain both variable and fixed costs, but variable costing avoid this problem since unit product costs does not include fixed costs (Myers par.
3). Variable costing is important for companies having cash flow problems because it net operating income is much closer to net cash flow rather than absorption costing net operating income (Garrison 290).
Although variable costing is useful for internal reports and decision making, it is not acceptable for external reports in United States and almost all other countries, and tax authorities require companies to use absorption costing for calculating income taxes (Fremgen).
Advantages and disadvantages of absorption costing Absorption costing is the most generally accepted method to prepare financial accounts for external reports and is accepted by Inland Revenue (Langholm 220).
Absorption costing shows less change in net profit when the company’s production remains unchanged but sales fluctuate (Langholm 223). Most companies find advantages of using variable costing and contribution approach for planning, controlling, and decision making purposes because absorption costing is considered not useful for such management purposes (Myers).
Since absorption costing is the total cost of both variable and fixed costs and is dependent on the level of activity which can differ every period, the cost volume profit is ignored. Moreover, under absorption costing, the variability of net income affected by production changes may cause confusion because net profit changes with both sales and stock. Therefore, this can result in opposite movement of net income and sales (Myers).
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