Question

Two observations can be made about variable and absorption costing. First, a variable costing income statement classifies cost based on behavior. An absorption costing income statement classifies cost based on character or nature (manufacturing, selling, administrative). 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?

Answer 1

Income Statement can be prepared on Contribution format basis ( Variable Costing) or Absorption costing basis. Management prepares both type of Income Statements to meet its various requirements

Purpose of Variable Costing Format Income Statement:

1. It helps in internal analysis for management . Management can see contribution analysis of Division, Products or Services
2. It helps management in taking reliable decisions like continue or discontinue the division or products
3. It helps in Break even analysis and calculating Margin of Safety
4. It helps in determining Optimal production schedule based on limited resources like machine hours, labor hours

Purpose of Absorption Costing Format Income Statement :

1. It treats Fixed manufacturing cost as product cost
2. It helps in valuing Closing inventory at full manufacturing cost ( including fixed cost)
3. It is useful for External reporting for regulatory purposes