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why is variable costing not allowed for gaap reporting

August 17, 2010
1. Traditional costing versus variable costing Traditional costing system is a systematic costing method that uses the volume-based cost drivers, such as direct-labor hours, direct-labor costs, or machine hours, to determine the cost of goods. compliance with financial reporting requirements. non-manufacturing costs are not analyzed. Variable costing system isa method of costing in which only variable production costs (direct material,direct labor, and variable overhead) are included as product costs and in which all fixed (production and non-production) costs are recognized as period costs. A variable costing system is not acceptable for external reporting. Like a traditional costing system a variable costing also has advantages and disadvantages. reflection of relationship between cost, price and volume; fixed costs are easier to identify. does not consider the fact that in the long run, fixed costs may become variable. 2.

Reasons variable costing is not permitted for external reporting According to the accounting standards for external financial reporting, the cost of inventory should include all costs to prepare the inventory for its intended use. This includes a reasonable portion of production overhead incurred in connection with manufacturing the inventory. Traditional costing includes all overhead costs (fixed and variable) into the cost of inventory, while variable costing treats all fixed overhead costs as period costs. Therefore, variable costing does not comply with the external reporting requirements. For external financial reporting under Generally Accepted Accounting Principles, as well as for tax reporting, companies are required to use absorption costing (also called Full costing).

Hence, there is no choice from the above table for external financial reporting. For internal reporting purposes, survey data suggests that approximately half of manufacturing companies use absorption costing and approximately half use variable costing. Absorption costing, variable costing and throughput costing are each associated with an income statement format: Absorption costing uses aPgross margin income statement, which starts with revenues and subtracts cost of goods sold to derive gross margin, then subtracts non-manufacturing costs to derive operating income. Virtually every income statement presented in connection with external financial reporting uses a gross margin format. Gross margin income statements separate manufacturing costs from non-manufacturing costs, which is helpful for certain types of analyses.

Variable costing uses aPcontribution margin income statement, which starts with revenues and subtracts variable costs (variable manufacturing costs related to units sold, plus all variable non-manufacturing costs) to derive contribution margin, then subtracts all fixed costs (manufacturing and non-manufacturing) to derive operating income. Contribution margin income statements facilitate cost-volume-profit analysis. It should be emphasized that under variable costing, not all variable costs appear on the income statement in the period incurred. Variable manufacturing costs that have been incurred to make inventory that hasnt been sold yet appear on the balance sheet as part of the cost of finished goods inventory.

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