Why isn't variable costing used for financial reporting?

1. Traditional costing versus variable costing

Traditional costing system is a systematic costing method that uses the volume-based cost drivers, such as direct-labor hours, direct-labor costs, or machine hours, to determine the cost of goods.

A traditional costing system has several advantages:

  • simplicity of the calculations of overhead rates;
  • lower costs to maintain; and
  • compliance with financial reporting requirements.

Some disadvantages of a traditional costing system are:

  • poor cause-and-effect allocation of overheads;
  • inability to provide accurate product costs in multiproduct companies; and
  • non-manufacturing costs are not analyzed.

Variable costing system isa method of costing in which only variable production costs (direct material,direct labor, and variable overhead) are included as product costs and in which all fixed (production and non-production) costs are recognized as period costs.

A variable costing system is not acceptable for external reporting.

Like a traditional costing system a variable costing also has advantages and disadvantages.

Some advantages of variable costing are:

  • reflection of relationship between cost, price and volume;
  • inventory changes do not affect profit;
  • applicable for decision making;
  • useful for cost volume profit (CVP) analysis;
  • income is not affected by changes in production volume;
  • fixed costs are easier to identify.

Some disadvantages are as follows:

  • unacceptable for external reporting and tax computing;
  • fixed costs are ignored in analysis;
  • does not consider the fact that in the long run, fixed costs may become variable.

2. Reasons variable costing is not permitted for external reporting

According to the accounting standards for external financial reporting, the cost of inventory should include all costs to prepare the inventory for its intended use. This includes a reasonable portion of production overhead incurred in connection with manufacturing the inventory.

Traditional costing includes all overhead costs (fixed and variable) into the cost of inventory, while variable costing treats all fixed overhead costs as period costs. Therefore, variable costing does not comply with the external reporting requirements.

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