Question

One of the disadvantages cited regarding variable costing is that this method of cost accumulation ignores generally accepted accounting principles (GAAP). Explain this. Why might auditors challenge the use of variable costing?

Answer 1

As per Generally accepted accounting principle (GAAP) Closing inventory is valued at product cost including fixed manufacturing overhead. But in Variable Costing Product cost consists of Variable cost only – Direct material, direct labor and Variable manufacturing overhead. Fixed manufacturing overhead is not part of product cost in variable costing and is charged to the period in which it is incurred. Hence Product cost in Variable costing does not meet the requirements of generally accepted accounting principle.

If closing stock is not valued as per the GAAP requirements Auditors are bound to question use of variable costing Income statement. Hence Absorption costing income statement is preferred for external reporting purpose over Variable costing income statement.