Managers often debate on whether to use variable costing or other cost methods such as absorption costing. Under absorption costing, accountants allocate all manufacturing labor, materials and overhead costs into the cost of a product. Variable costing only includes variable labor, materials and overhead costs in the product. Fixed manufacturing overhead expenses such as factory rent and property taxes are excluded from product cost.
Most companies use absorption costing at some point in their accounting process. According to U.S. generally accepted accounting principles, companies must use absorption costing to value their inventory on financial statements. The Internal Revenue Service requires it for taxes. However, absorption costing isn't terribly helpful for management decision-making, because it includes costs that don't have a direct relationship with the product. Because of this, many companies choose to use variable costing when making strategic decisions.
It's easier to understand the relationship between costs, profits and volume when solely looking at variable costs. The marginal cost of producing an item may go down after a certain level, because the company can buy materials in bulk. Workers often become more efficient at a certain level of production. Variable costing isolates these variables and can help management identify what level of production is the most profitable. Cost-volume-profit analysis also allows management to identify the "breakeven" point of production -- the cost below which the company will stop making a profit.
It's easier to make decisions about product lines using variable costing. That's because absorption costing includes fixed costs in the product that may still exist if the company drops the product line. For example, consider a factory that produces three product lines. Under absorption costing, each product absorbs one-third of factory manager salaries, factory rent and property tax. However, the company will still have to pay those costs if they drop one of the product lines, so the product costs are inflated. In contrast, variable costing allows managers to clearly see the profit affects of adding and subtracting products.
Income statements based on absorption costing and variable costing look at profits in different ways. Absorption costing includes overhead expenses in the value of inventory. The problem is, inventory is presented as an asset on the balance sheet. When a company produces inventory that it sells, it converts some of those overhead expenses into an asset. This makes expenses seem lower and creates a phantom profit on the income statement. If managers overestimate the profitability of product lines, they don't have as much time to correct profitability problems. In contrast, variable costing expenses overhead costs in the period they were produced so profits aren't skewed.
