Question

Two observations can be made about variable and absorption costing. First, a variable costing income statement classifies cost based on behavior, variable or fixed. An absorption costing income statement classifies cost based on nature (use in manufacturing or selling and administration, etc.). Second, in variable costing income statements, fixed manufacturing costs are excluded from inventoriable costs. In absorption costing income statements, fixed manufacturing costs are included in inventoriable costs. Many large companies prepare both kinds of income statements. For what purpose? Why does this make sense to you now that you have completed a semester of Cost Accounting study?

Answer 1

Both Absorption and Variable costing income statement are prepared by many organisations depending on the purpose it needs. It makes sense to prepare both income statements since purpose of stakeholders is different. Absorption costing is mostly used for external purpose and Variable costing statements for internal purpose.

Purpose of Absorption costing income statement:

· Helps in valuing closing inventory and cost of goods sold at product cost including fixed manufacturing cost for external reporting purpose as per accounting principles and standards. . Closing inventory is reported in Balance sheet and Cost of goods sold is reported in Income statement.

· Gives full picture of manufacturing cost absorbed by cost of goods sold and carried in closing inventory

· Helpful in certain cases like insurance claim for damages of inventory.

Purpose of Variable costing income statement:

· Useful for internal decision making purpose like make vs. buy, acceptance of special order, continue or discontinue product line or division, sell or process further ,etc

· Helps in analysing profitablity statement at different levels of activity since cost is analysed based on behaviour- variable and fixed.

· Helps in evaluation of new investment alternatives and selecting best one.

· Helps in cost volume profit analysis and analysing breakeven point

· Helps in new product launches and product pricing. For example: variable cost pricing, full cost pricing, cost plus pricing, etc