Question

All things equal, which would be superior: variable or absorption costing?

If you were take away the pros and cons of both the variable costing and absorption costing and look at them for their face value, which system would be the better of the two? Realistically I know that that is not possible and I do understand that absorption costing and variable costing each have their own purposes and uses; however, from the standpoint of a company I am trying to understand the practicality of absorption versus variable costing (if both are considered to be equal).

What I mean by that exactly is, I see (and favor) variable costing as a way of being able to more quickly assist management in making their decisions in regard to a specific product's profitability. The expenses are broken out into line items and (to me) it's much more clear on the various expenses going into a certain product. For example, if there were to be a material change, which also decreased the amount of direct labor and as result the per unit price were to decrease, those changes are able to be easily identified rather than just being all lumped together in one line item.

With absorption costing, I see it more as summary and I think that the long-term decisions could be hindered or made incorrectly.

Answer 1

I do agree with your opinion that in most cases variable costing will be more advantageous for the company than absorption costing especially because it makes it easier for a company to compare the potential profitability of manufacturing one product over another and hence helps in determining the profitability of each product.

However at the same time, it is not true in all cases. There are certain companies whose production process or products are such that absorption costing is better. Also absorption costing is also sometimes better from the statutory point of view. Following are some points where absorption costing ends up being a better choice :

1. Most important of the reason is that absorption costing is required to be followed by a company to be in compliance with the generally accepted accounting principles (GAAP) and it is also required for tax filings and hence a company is compulsorily required to follow it. They can decide to follow variable costing for their internal purposes but they have to follow absorption costing for the above mentioned statutory purposes.

2. Some companies have such production lines/processes where a single expense is being incurred for multiple products and it becomes very difficult to determine the exact amount of that expense being incurred for which product and hence in such cases we have to use an allocation basis for dividing cost of such expense among various products for which absorption costing is required.

3. In some companies fixed costs such as advertising are very important. Variable costs for a particular product may not be that much but at the same time it may require heavy advertising expenditure. Hence in this respect absorption costing is more appropriate because variable costing does not take fixed expenses into consideration whereas absorption costing divides all costs among products.

Hence to conclude, I would like to say it depends more on the circumstances of the company. In some companies it is absolutely essential to follow variable costing where they have multiple products and direct costs outweigh other costs by a big margin. Whereas in companies producing a single product or limited number of products, absorption costing will be preferred as they are required to follow it by law any way and it might not be feasible for them to follow 2 costing methods.