Advantages of the Contribution Approach.

There are a number of advantages to using

variable costing (and the contribution approach) in internal reports and analysis.

1. More useful for CVP analysis. Variable costing statements provide data that are immediately
useful for CVP analysis since they categorize costs on the basis of their behavior. In contrast, it
is often difficult to rework absorption costing data so that they can be used in CVP analysis and
in decisions.

2. Income is not affected by changes in production volume. Under absorption costing,

reported net operating income is affected by changes in production since fixed costs are spread
across more or fewer units. This can distort income and may even result in income moving in an
opposite direction from sales. This does not occur under variable costing.

3. Avoids misunderstandings concerning unit product costs. Absorption costing unit product
costs can be easily misinterpreted as variable costs since they are stated on a per unit basis. Such
a misperception can lead to serious errors in making decisions. Variable costing avoids this
problem since unit costs include only variable costs.

4. Fixed costs are more visible. The impact of fixed costs on profits is emphasized because the
total amount of such costs for the period appears separately and is highlighted in the income
statement rather than being buried in cost of goods sold and ending inventory.

5. Understandability. Managers should find it easier to understand variable costing reports

because data are organized by behavior and because variable costing is much closer to cash flow.

6. Control is facilitated. Variable costing ties in with cost control methods such as flexible
budgets.

7. Incremental analysis is more straight-forward. Variable cost corresponds closely with the
current out-of-pocket expenditure necessary to produce and sell products and services and can
therefore be used more readily in incremental analysis than absorption costing data. And since
variable costing net operating income is closer to net cash flow than absorption costing net
operating income, it is likely to be more useful to companies that have cash flow problems.

However, variable costing is not generally accepted by auditors for external financial reports and
is not permitted by the IRS in the United States and by tax authorities in many other countries for
income tax calculations. There is some question about whether variable costing is actually
prohibited in the United States by official pronouncements and some companies do use some
form of variable costing in their external reports, but absorption costing must be considered the
most generally accepted practice.