The Matching Principles 

Accountants and managers have been arguing for decades concerning the relative merits of absorption and variable costing. In practice, absorption costing is used far more than variable costing even for internal reports. The reasons for this are not entirely clear, although the perception that absorption costing is required for external reporting undoubtedly plays a key role. The argument for using absorption costing in external reports seems to be based on the matching principle.

1. Argument for absorption costing

Advocates of absorption costing argue that all manufacturing costs must be assigned to units of product so as to properly match costs with revenues. They argue that fixed manufacturing overhead costs are essential to the production process and must be included when costing units of product, regardless of how the cost behaves.

2. Argument for variable costing

Advocates of variable costing argue that fixed manufacturing overhead costs are incurred in order to have the capacity to produce. Moreover, they will be incurred regardless of whether anything is actually produced. Since these costs are not caused by any particular unit of product and are incurred to provide capacity for a particular period, the matching principle would dictate that fixed manufacturing overhead costs must be expensed in the current period.

Advantages of Variable Costing

Advantages of Variable Costing and the Contribution Approach

There are a number of advantages to using variable costing (and the contribution approach) in internal reports and analysis.

 1. More useful for CVP analysis

Variable costing statements provide data that are immediately useful for CVP analysis since they categorize costs on the basis of their behavior. In contrast, it is often difficult to rework absorption costing data so that they can be used in CVP analysis and in decisions.

 2. Income is not affected by changes in production volume

Under absorption costing, reported net operating income is affected by changes in production since fixed costs are spread across more or fewer units. This can distort income and may even result in income moving in an opposite direction from sales. This does not occur under variable costing.

 3. Avoids misunderstandings concerning unit product costs

Absorption costing unit product costs can be easily misinterpreted as variable costs since they are stated on a per unit basis. Such a misperception can lead to serious errors in making decisions. Variable costing avoids this problem since unit costs include only variable costs.

 4. Fixed costs are more visible

The impact of fixed costs on profits is emphasized because the total amount of such costs for the period appears separately and is highlighted in the income statement rather than being buried in cost of goods sold and ending inventory.

 5. Understandability

Managers should find it easier to understand variable costing reports because data are organized by behavior and because variable costing is much closer to cash flow.

6. Control is facilitated

Variable costing ties in with cost control methods such as flexible budgets.

7. Incremental analysis is more straight-forward

Variable cost corresponds closely with the current out-of-pocket expenditure necessary to produce and sell products and services and can therefore be used more readily in incremental analysis than absorption costing data. And since variable costing net operating income is closer to net cash flow than absorption costing net operating income, it is likely to be more useful to companies that have cash flow problems.

However, variable costing is not generally accepted by auditors for external financial reports and is not permitted by the IRS in the United States and by tax authorities in many other countries for income tax calculations. There is some question about whether variable costing is actually prohibited in the United States by official pronouncements and some companies do use some form of variable costing in their external reports, but absorption costing must be considered the most generally accepted practice.