Variable costing includes all the variable expenses in the calculation of an item’s total production cost. These expenses include direct costs, such as the price of raw materials and cost of labor. Another expense included in variable costing is variable manufacturing overheads; it includes electricity and water costs. On the other hand, absorption costing includes all variable expenses plus fixed manufacturing costs, such as depreciation and property tax.
According to the Generally Accepted Accounting Principles, companies must use absorption instead of variable costing when preparing financial statements for shareholders and the public. Absorption costing is recommended because it takes into consideration all the manufacturing expenses. As a result, the closing inventory in the balance sheet will be more when absolute costing is used to determine the manufacturing expenses.
Since variable costing is not allowed in external reporting, it is used internally by managers to make crucial decisions. The best way for businesses to manage their expenses is to control variable costs. Before the firm decides whether or not it wants to get rid of a variable expense, it must calculate the contribution margin (total revenues – variable costs). If this amount can settle the fixed costs and still have some leftover change, the variable costs are sufficient.