Question

What are the advantages of a company doing both variable costing analysis and absorption costing analysis?

Answer 1

Variable costing analysis :

•Variable costing is also best known for direct costing method and generally used for internal purposes.

•This method directly allocates variable production costs and also direct materials to inventory

• all fixed production costs (fixed manufacturing overhead) reported as period costs

* In variable costing

Direct materials + Direct labour + variable manufacturing overhead = Product costs

Fixed manufacturing overhead + selling and administrative = Period costs

Absorption costing analysis :

•In Absorption costing includes all costs of manufacturing i.e.both fixed and variable costs

•It is also known as full costing as it covers all the direct cost related to manufacturing and generally used for external purpose

* In Absorption costing

Direct materials + Direct labor + variable manufacturing overhead + Fixed manufacturing overhead = Product costs

Selling and administrative = Period costs

Main merits of variables costing are as follows :

- it provides the company all essential data for CVP (cost volume profit) analysis

- mostly every organization bothers about profit determination which is very easy to determine profit under variable costing

- variable costing helps the management in the matter of cost control and understand the effect and facilitates better decision making.

Main merits of absorption costing are as follows:

- very useful method to determine the actual cost of production

- as absorption costing is used for external purposes it is useful for tax authority, investors etc.

- provides balance sheet true and fair view

Final thoughts :

* companies using variable costing provides a better understanding of the effect of fixed costs on net profit on income statement.

* net operating income produced by variable costing is useful for business of cash flow

Relationship between production and sales	Effect on Inventory	Relation between variable and absorption income
Production > sales	inventory increases	Absorption > Variable
Production < sales	inventory decreases	Absorption < Variable
Production = sales	no change	Absorption = Variable

* To conform to GAAP requirements, absorption costing must be used for external financial reports in the United States

*under the Tax reform Act of 1986 absorption costing must be used when filing income tax returns