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.