What are advantages and disadvantages of variable costing system?
Companies need absorption costing to prepare statements to satisfy external parties and variable costing for better management. Both the costing methods have benefits and limitations. Following are the main advantages and disadvantages of variable costing system:
- Variable costing provides a better understanding of the effect of fixed costs on the net profits because total fixed cost for the period is shown on the income statement.
- Various methods of controlling costs such as standard costing system and flexible budgets have close relation with the variable costing system. Understanding variable costing system makes the use of those methods easy.
- Companies using variable costing system prepare income statement in contribution margin format that provides necessary information for cost volume profit (CVP) analysis. This data cannot be directly obtained from a traditional income statement prepared under absorption costing system.
- The net operating income figure produced by variable costing is usually close to the flow of cash. It is useful for businesses with a problem of cash flows.
- Under absorption costing system, income of different periods changes with the change of inventory levels. Sometime income and sales move in opposite directions. But it does not happen under variable costing.
- Financial statements prepared under variable costing method do not conform to generally accepted accounting principles (GAAP). The auditors may refuse to accept them.
- Tax laws of various countries require the use of absorption costing.
- Variable costing does not assign fixed cost to units of products. So the production costs cannot be truly matched with revenues.
- Absorption costing is usually the base for evaluating top executive’s efficiency.