Organizations need variable costing for better management and absorption costing to prepare statements to satisfy external parties. Although both the costing methods have advantages and limitations, variable costing is challenging to work with. Foremost, the method is not accepted for tax and external reporting since it does not conform to Generally Accepted Accounting Principles (GAAP).
Variable costing requires that all cost s should be grouped as either variable or cost elements. The method also assumes that sales and the variable costs have a direct, linear, and proportionate relation. The assumption may not be correct under all circumstances, such as when labor efficiency variance and quantity discount on the material is present (Hasan, 2015). Variable costing provides inaccurate cost because it does not include fixed cost when computing product cost s . This exclusion of fixed cost is difficult to accept because product cost does not depend only on variable s .
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Notably, when the method is the only one used in the organization, managers may be coaxed to reduces prices to the extent that the firm’s revenue becomes negatively affected. That happens because the method produces product amounts rendering small rationale for long-range strategies. It is not useful for long-term pricing because it does not regard fixed factory overhead as product cost (Hasan, 2015). An example is during the business recession, where the results of variable costing may mislead management. Under a recession situation, variable costing profits will be minimized due to sales being significantly lower than production.
When the method is used, the organization’s balance sheet cannot indicate an accurate and fair view; it undervalues inventories like finished good s and works in progress simply because of the non-inclusion of fixed factory overhead in product cost (Hasan, 2015). Lastly, the separation of costs into fixed and variable costs is difficult, especially when such costs are semi-variable.
Reference
Hasan, M. (2015). Variable Costing and Its Application in Manufacturing Companies . International Scholar Journal of Accounting and Finance, 5(1). https://papers.ssrn.com/sol3/Delivery.cfm/SSRN_ID2678837_code2460757.pdf?abstractid=2675830&mirid=1
