Variable Costing System
A Decision Making Tool for Management:

Learning Objectives:

1. Explain how variable costing differs from absorption costing and compute unit product costs under each method
2. Prepare income statements using variable and absorption costing.
3. Reconcile variable and absorption costing net operating income and explain why two amounts differ.
4. Understand the advantages and disadvantages of both variable and absorption costing.

Two general approaches are used for valuing inventories and cost of goods sold. One approach is called variable costing and other is called absorption costing. Absorption costing is generally used for external financial reports and variable costing is preferred by managers for internal decision making and must be used when an income statement is prepared in the contribution margin format. Ordinarily these two costing systems produce different figures for net operating income and difference can be quite large. The reason of this difference is well explained on the following pages. Click on a link for detailed study.

Variable Costing Vs Absorption Costing:

Absorption costing is a costing system which treats all costs of production as product costs, regardless weather they are variable or fixed. Variable costing is a costing system under which those costs of production that vary with output are treated as product costs. Click here to read full article

Income Comparison of Variable and Absorption Costing:

Net operating income is usually different under variable and absorption costing system. The explanation for this difference needs two separate income statements one under absorption costing and other under variable costing. Click here to read full article

Advantages and Disadvantages of Absorption Costing:
Click here to read advantages and disadvantages of absorption costing.

Limitations of variable costing--GAAP and External Reports:

A company that attempts to use variable costing on its external financial reports runs the risk that its auditors may not accepts the financial statements as conforming to generally accepted accounting principles (GAAP). Tax laws almost all over the world require the usage of a form of absorption costing for filling out income tax forms. Click here to read full article

Advantages of Variable Costing:

The absorption approach is used for external reporting purposes, variable costing, together with contribution margin format income statement, is an appropriate appealing alternative for internal reports. Click here to read full article

Variable Costing and Theory of Constraints:

The Theory of Constraints (TOC) focuses on managing constraints in a company as the key to improving profits. Companies involved in Theory of Constraints (TOC) use a form of variable costing. Click here to read full article

Impact of Just In Time (JIT) Inventory Methods:

Variable and absorption costing produce different net operating income figures whenever the number of units produced is different from the number of units sold. In other words, whenever there is a change in the number of units in inventory. Absorption costing net operating income figure can be erratic, sometimes moving in a direction that is opposite from the movement in sales. When companies use just in time (JIT) methods, these problems are reduced. Click here to read full article

Variable | Direct Costing and Absorption Costing Discussion Questions and Answers:
Click here to find answers of various questions about variable and absorption costing system.

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