Variable costing is a particular method companies use to determine product cost. Managerial accountants report this information to owners and managers who use the data to make decisions. Variable costing has both advantages and disadvantages for businesses. In many cases, variable costing faces a comparison with absorption costing, another costing method.
Advantage: Unaffected by Inventory Changes
Companies that use variable costing experience fewer cost changes from inventory adjustments. For example, changes in product cost, selling price or the company’s sales mix will not affect the profit for a single accounting period. Companies can expect smoother profit reporting throughout multiple accounting periods, making forecasting costs from production increases easier.
Advantage: Profitability Estimating
Estimating future profits is often easier with variable costing when compared to absorption costing. Fewer changes to inventory costs will result in a better historical record of actual production costs. Companies can also break down each department or product line under variable costing, which provides a more thorough analysis of a company’s business operations. Adding new products or expanding current production levels also relies on this consistent information.
Disadvantage: Non-Conforming Method
A significant disadvantage with variable costing is that it does not conform to generally accepted accounting principles. While companies can use this reporting method, auditors may challenge the use of variable costing. Generally Accepted Accounting Principles (GAAP) has no preference as to how variable fixed costs are handled in a company’s production process. Variable costing expenses fixed costs rather than adding them to products, creating a distortion for actual production costs.
Disadvantage: Lower Net Income
Another issue with variable costing is the reduction of reported net income. Expensing fixed production costs as a period expense lowers net income for each accounting period. Companies will face lower tax liabilities from government agencies, saving the business money. Government agencies, however, can see this as inappropriate financial reporting and challenge the company’s financial accounting method.