Variable Vs.

Absorption
Most companies use absorption costing at some point in their accounting process. According to
U.S. generally accepted accounting principles, companies must use absorption costing to value
their inventory on financial statements. The Internal Revenue Service requires it for taxes.
However, absorption costing isn't terribly helpful for management decision-making, because it
includes costs that don't have a direct relationship with the product. Because of this, many
companies choose to use variable costing when making strategic decisions.

Understanding The Cost-Volume-Profit Relationship

It's easier to understand the relationship between costs, profits and volume when solely looking at
variable costs. The marginal cost of producing an item may go down after a certain level, because
the company can buy materials in bulk. Workers often become more efficient at a certain level of
production. Variable costing isolates these variables and can help management identify what level
of production is the most profitable. Cost-volume-profit analysis also allows management to
identify the "breakeven" point of production -- the cost below which the company will stop making a
profit.

Comparing Product Lines

It's easier to make decisions about product lines using variable costing. That's because absorption
costing includes fixed costs in the product that may still exist if the company drops the product line.
For example, consider a factory that produces three product lines. Under absorption costing, each
product absorbs one-third of factory manager salaries, factory rent and property tax. However, the
company will still have to pay those costs if they drop one of the product lines, so the product
costs are inflated. In contrast, variable costing allows managers to clearly see the profit affects of
adding and subtracting products.

No Phantom Profits
Income statements based on absorption costing and variable costing look at profits in different
ways. Absorption costing includes overhead expenses in the value of inventory. The problem is,
inventory is presented as an asset on the balance sheet. When a company produces inventory
that it sells, it converts some of those overhead expenses into an asset. This makes expenses
seem lower and creates a phantom profit on the income statement. If managers overestimate the
profitability of product lines, they don't have as much time to correct profitability problems. In
contrast, variable costing expenses overhead costs in the period they were produced so profits
aren't skewe