Compare absorption costing and variable costing, and discuss when each is appropriate in decision making.

• A. Absorption includes fixed overhead in product cost; variable excludes fixed overhead; use absorption for external reporting; variable for decision-making and performance evaluation.
• B. Absorption excludes fixed overhead; variable includes fixed overhead; use variable for external reporting.
• C. Absorption and variable costing are identical.
• D. Absorption is for internal use only; variable is for external reporting.

Answer: (A)

The main idea is how each costing method treats fixed manufacturing overhead and how that affects usefulness in different contexts. Absorption costing allocates fixed manufacturing overhead into product costs along with direct materials and direct labor, so the cost of a unit includes both variable and fixed manufacturing costs. Variable costing, on the other hand, treats fixed overhead as a period expense and only assigns variable manufacturing costs to the product.

This distinction matters for reporting and decision making. For external financial reporting, absorption costing is the appropriate method because it matches all manufacturing costs to the units produced, keeping inventory values higher by including fixed overhead in inventory. For internal decision making and performance evaluation, variable costing is preferable because it reveals the incremental, or variable, costs of producing a unit and avoids distorting product costs when production levels change. It also makes it clearer how profits respond to decisions like pricing, added capacity, or changes in production volume, since fixed overhead is treated as a period cost and not allocated to each unit.

In short, absorption costing is used for external reporting due to its full-cost product valuation, while variable costing is used for internal decision making and performance evaluation due to its focus on variable, changeable costs.