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    Variable, Absorption Costing, and Operating Leverage

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    Please help me understand:

    1. Cons of using Variable Costing
    2. Cons of using Absorption Costing
    3. Indicate what contribution margin is and how it can be expressed.
    4. What is "Operating Leverage"? How does this affect Profitability?

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    Solution Preview

    1. The biggest problem with variable costing is that it is not permitted under GAAP for financial reporting purposes. If a company uses variable costing, it must be for internal reporting purposes only. Absorption costing must be used for financial statement preparation purposes. Variable costing cannot be used. Management therefore has to run two different costing methods, one for financial reporting purposes and one for internal reporting purposes, if they wish to use variable costing. This means that management incurs greater expense due to the time it takes to use two different methods. Another main con is that with variable costing, fixed production expenses become a period cost which lowers net income. If a company is trying to keep their net income high to attract investors or obtain bank financing, this is more ...

    Solution Summary

    This solution explains the problems and disadvantages with using variable costing. I also explain the disadvantages of using absorption costing. Contribution margin is explained, including how it can be expressed, along with a thorough explanation for operating leverage and how operating leverage affects a company's profitability.

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