Advantages and disadvantages of variable costing

Companies follow an absorption costing approach to prepare financial statements to satisfy the information needs of external parties and use variable costing as a tool for better management of their business. Both costing methods have their own benefits and limitations. Following are the main advantages and disadvantages of a variable costing system:

Advantages of variable costing approach

The financial statements prepared on the basis of the variable costing approach offer the following advantages or benefits to the companies:

1. Variable costing provides a better understanding of how fixed cost affects the net profit of the company for a specific period because the total fixed manufacturing overhead for the period is shown on the income statement.
2. Various cost controlling methods, such as the standard costing system and flexible budgets, have a close relation with the variable costing system. Therefore, a proper understanding of variable costing systems makes the use of these methods easy.
3. When companies follow a variable costing system, they prepare their 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, which is prepared under the absorption costing system.
4. The net operating income figure produced by a variable costing approach is usually close to the flow of cash. It is, therefore, useful for businesses with a cash flow problem.
5. Under absorption costing system, the net operating income of different periods changes with the change in inventory levels. Sometimes income and sales move in opposite directions. This issue, however, does not arise under the variable costing approach.

Disadvantages or limitations of variable costing approach

The variable costing financial statements have the following disadvantages or limitations:

1. Financial statements prepared under the variable costing method do not conform to generally accepted accounting principles (GAAP). The auditors may refuse to accept them.
2. The tax laws in many countries require business entities to use a full or absorption costing approach. Therefore, the financial statements prepared on the basis of a variable costing approach are often not accepted by tax authorities.
3. Variable costing does not assign fixed manufacturing overhead cost to units of products. Hence, the production costs cannot be truly matched with the revenues generated in the current period.
4. Absorption costing is generally the basis for evaluating the efficiency of top executives. The operating results shown by the variable costing system of the company often remain irrelevant in this regard.

Click here to read the benefits and limitations of absorption costing system.

Practice exercises and problems
Practice quizzes