In the production stage of a product’s life cycle, companies must allocate costs incurred to determine a product's total production cost. Costs can be allocated to a product using either of the two methods: variable and absorption costing. In variable costing, costs are divided into fixed and variable segments, with the fixed costs being treated as period costs. However, absorption costing assigns all costs to a product as a single lump sum, regardless of whether they are fixed or variable.
While recording and summarizing financial transactions, accountants follow a set of rules and conventions known as the generally accepted accounting principles (GAAP).These principles don’t recognize variable costing as the technique for reporting costs in financial statements. Variable costs such as direct materials, direct labor and variable manufacturing overhead are added as product costs, while all the total fixed costs are expensed in the year of production as period costs. This is in conflict with the GAAP requirement that all costs of manufacturing a particular product be expensed at once.
Variable costing is not accepted by GAAP because it reports a lower taxable figure as inventory increases. In the eyes of the Internal Revenue Service, lower taxable income means less tax revenue. Hence, to ensure fairness in tax collection, GAAP advocates the use of the absorption costing method in reporting the costs of production, since taxable profits increase proportionately with increase in inventory sales.
The variable costing approach doesn’t provide correct matching of costs because fixed costs incurred in manufacturing the inventory are charged to expenses, irrespective of whether the inventory is sold in the period or not. This fact prevents the variable costing approach from being used for external reporting purposes. However, variable costing is used in managerial decision making through the use of the cost-volume-profit (CVP) analysis technique. CVP analysis is a model used to identify the appropriate operating activity levels required to prevent losses, attain targeted profits and monitor organizational performance.
Managers as agents of shareholders have a duty to protect and generally increase the value of the shareholders’ wealth. One avenue through which shareholders can monitor the progress of the management is through financial statements. Since the variable costing approach doesn’t present accurate income figures, it is not allowed in the preparation of financial statements for external users. This is one of the premises on which the GAAP disallows the use of variable costing in the preparation of financial statements.
In preparing financial statements, the GAAP states that the cost of inventory should include all costs incurred in the production of the inventory. This includes a reasonable portion of fixed manufacturing costs incurred to produce the inventory. The variable costing approach ignores such fixed manufacturing costs, thereby understating the overall cost of the product.