Comparing the Usefulness of Variable and Absorption Costing
Absorption and variable costing are two methods often used in management accounting, and both are useful but have different features. Contrarily, variable costing indicates manufacturing costs as product costs, including direct labor and materials. In this case, fixed manufacturing costs are considered period one (Harrison & Horngren, 2008).
Variable costing shows a clear view of the contribution margin, provides an accurate understanding of the cost-volume-profit connections, and is helpful in internal decision-making. On the other hand, absorption costing combines fixed and variable manufacturing costs and includes fixed manufacturing overhead as a product cost. These costs are based on predetermined overhead rates, and this type of costing is useful for external financial reports in the USA (Harrison & Horngren, 2008). Absorption costs include all production costs and produced units.
Impact on Operating Income When Units Produced Equal Units Sold
Nevertheless, if equal units are sold, the operating income between the two types of costing would be equal. In this case, fixed and variable expenses will be considered expenses under absorption, so their outcomes would be the same (Harrison & Horngren, 2008). Hence, absorption and variable costing are helpful, but absorption is more accurate and can address all costing parts.
Why US GAAP Mandates Absorption Costing for External Reporting
The absorption costing is required by US GAAP for external financial reports due to its effectiveness. Firstly, absorption costings demonstrate the complete overview of costs, including variable and fixed costs. Secondly, costs should match revenue, and absorption can effectively provide it.
Moreover, absorption costing prevents companies from manipulating their finances, as fixed costs are included. In addition, the average cost, FIFO, and LIFO can be used to find the allocation of costs (Harrison & Horngren, 2008). Lastly, absorption costing provides comparability. As a result, it is easier to compare companies in similar industries and their revenue. Therefore, absorption costing is required by US GAAP due to its inclusion in all financial aspects.
Reference
Harrison, W. T., Jr., & Horngren, C. T. (2008). Financial Accounting (7th ed.). Upper Saddle River, NJ: Pearson Education, Inc.