Variable costing

What Is Variable Costing?

Variable costing, also known as direct costing or marginal costing, is an accounting method used primarily in managerial accounting that includes only variable production costs in the cost of a product. Unlike other costing methods, it treats all fixed costs, such as factory rent or depreciation, as period costs that are expensed in the period they are incurred, regardless of production volume⁶⁴, ⁶⁵. This approach contrasts with traditional absorption costing, which includes both fixed and variable manufacturing costs in the cost of a product⁶³. Variable costing is a crucial tool for internal decision making within a company, offering insights into how costs behave with changes in production volume⁶².

History and Origin

The concept of variable costing, often referred to as direct costing in its early days, gained prominence in the field of cost accounting as a response to the evolving needs of businesses for better internal reporting and control. Its development was influenced by a shift in emphasis from mere cost ascertainment to more sophisticated cost control and planning⁶⁰, ⁶¹. Early accounting practices were focused on determining past costs for product valuation, leading to the development of absorption costing⁵⁹.

However, as businesses became more complex, there arose a need for a costing method that could more clearly differentiate between costs that varied with production and those that remained constant. This need was particularly highlighted by early contributors such as Jonathan N. Harris, who emphasized the importance of direct costing for internal reporting in American accounting literature prior to World War II⁵⁸. The method is founded on the fundamental differentiation between fixed and variable costs and aims to provide a multi-step income statement that reflects this distinction⁵⁶, ⁵⁷. The evolution of direct costing was further propelled by the growth of "scientific management" between 1890 and 1915, which pushed for the integration of cost accounting within general accounts to measure performance and facilitate planning⁵⁵.

Key Takeaways

• Variable costing only includes variable manufacturing costs—direct materials, direct labor, and variable overhead—in the cost of a product.
• ⁵³, ⁵⁴ Fixed manufacturing costs are treated as period expenses and are expensed in the period they are incurred, not as part of product cost.
• ⁵¹, ⁵² It is widely used for internal management purposes, such as pricing strategies, production decisions, and profitability analysis.
• ⁴⁹, ⁵⁰ Variable costing is not compliant with Generally Accepted Accounting Principles (GAAP) for external financial reporting.
• ⁴⁸ The method emphasizes the contribution margin, which is key for cost-volume-profit analysis.

##⁴⁶, ⁴⁷ Formula and Calculation

The core of variable costing lies in identifying and aggregating only the variable costs associated with production. The variable product cost per unit is calculated as follows:

In this formula:

• Direct Materials Per Unit refers to the cost of raw materials directly incorporated into each unit of product.
• Direct Labor Per Unit represents the wages paid to workers directly involved in manufacturing each unit.
• Variable Manufacturing Overhead Per Unit includes indirect manufacturing costs that fluctuate with the level of production, such as electricity for machinery or indirect supplies.

For internal reporting, a variable costing income statement (often called a contribution margin income statement) separates costs by their behavior, distinguishing between variable and fixed expenses. Th⁴⁵e contribution margin is a crucial component, calculated by subtracting total variable costs from total sales revenue.

Interpreting Variable Costing

Interpreting variable costing statements primarily focuses on the behavior of costs relative to production and sales volume, and its emphasis on the contribution margin. Because variable costing separates fixed and variable expenses, managers can clearly see how changes in sales volume directly impact profitability. The contribution margin, which is sales revenue minus all variable costs, indicates the amount of revenue available to cover fixed costs and contribute to profit.

A⁴⁴ higher contribution margin per unit suggests that each additional unit sold contributes more towards covering fixed expenses and generating profit. This clarity aids in short-term decision making, especially concerning special orders, production levels, and pricing. Managers can quickly assess the incremental profit from producing and selling additional units, as fixed costs are not allocated to individual products and remain constant within a relevant range. Th⁴³is approach provides a more transparent view of the costs directly incurred by producing an extra unit, fostering better operational insights.

Hypothetical Example

Consider a small furniture manufacturer, "CraftCo," that produces custom tables.
For March, CraftCo has the following information:

• Sales price per table: $300
• Direct materials per table: $80
• Direct labor per table: $60
• Variable overhead per table: $20 (e.g., electricity for saws, sandpaper)
• Fixed manufacturing overhead: $15,000 (e.g., factory rent, machinery depreciation)
• Fixed selling and administrative expenses: $10,000
• Units produced: 200 tables
• Units sold: 180 tables

Step 1: Calculate Variable Product Cost Per Unit
Variable Product Cost Per Unit = Direct Materials + Direct Labor + Variable Overhead
Variable Product Cost Per Unit = $80 + $60 + $20 = $160 per table

Step 2: Prepare a Variable Costing Income Statement

In this scenario, under variable costing, the 20 unsold tables (200 produced - 180 sold) would have an inventory valuation of $160 per unit (only variable costs), and the $15,000 fixed manufacturing overhead would be fully expensed in March. This income statement format directly highlights the contribution of sales to covering fixed costs, which is critical for internal operational insights.

Practical Applications

Variable costing serves as a powerful internal management tool, offering insights distinct from those provided by financial accounting. Its primary utility lies in facilitating informed decision making by clearly delineating cost behavior.

Key practical applications include:

• Break-Even Analysis and Cost-Volume-Profit Analysis: By isolating variable costs, businesses can readily calculate their contribution margin per unit and total contribution margin. This allows for precise determination of the break-even point—the sales volume needed to cover all fixed costs. This information is crucial for planning production levels and setting sales targets.
• ⁴⁰, ⁴¹, ⁴²Special Order Decisions: When evaluating a special, one-time order, variable costing helps management determine if the selling price covers the incremental variable costs. If the company has excess capacity, accepting an order at a price above its variable cost per unit will contribute positively to covering fixed costs and increasing profit, even if the price is below the "full" cost calculated under absorption costing.
• ³⁹Pricing Strategies: Variable costing provides a floor for pricing decisions. A product must at least cover its variable costs to contribute to profitability in the short run. This can be particularly useful in highly competitive markets or for promotional pricing.
• ³⁷, ³⁸Performance Evaluation: Managers can be evaluated on their ability to control variable costs and generate contribution margin, as fixed costs are often outside their direct control in the short term. This aligns incentives with operational efficiency.
• ³⁶Budgeting and Forecasting: Separating costs into fixed and variable components simplifies the budgeting process, as variable costs can be projected based on anticipated sales or production volumes, while fixed costs are treated as constant. This clarity aids in financial forecasting for various activity levels.

For³⁵ example, when a company considers expanding production, understanding its variable costs helps it predict the additional expenses it will incur, allowing for more accurate projections of profitability at higher volumes. As noted by Lumen Learning, variable costing provides more accurate information for decision makers as costs are better tied to production levels.

³⁴Limitations and Criticisms

Despite its advantages for internal management, variable costing has several notable limitations and criticisms, primarily concerning its suitability for external reporting and its potential to mislead in certain contexts.

• Non-Compliance with GAAP: The most significant limitation is that variable costing does not adhere to Generally Accepted Accounting Principles (GAAP) in the United States, nor with International Financial Reporting Standards (IFRS), for external financial reporting. GAAP³², ³³ requires that all manufacturing costs, both fixed and variable, be included in product costs (absorption costing) for inventory valuation and cost of goods sold. This³⁰, ³¹ non-compliance means companies must convert their internal variable costing records to absorption costing for public financial statements, adding an additional accounting burden.
• ²⁹Violation of the Matching Principle: Variable costing is criticized for poorly upholding the matching principle, a fundamental accounting concept that requires expenses to be recognized in the same period as the revenues they help generate. Unde²⁸r variable costing, fixed manufacturing overheads are expensed entirely in the period incurred, even if the goods produced are not yet sold and remain in inventory. This can lead to a mismatch between revenues and expenses on the income statement, particularly when inventory levels fluctuate significantly.
• ²⁶, ²⁷Undervaluation of Inventory: For external reporting purposes, variable costing results in a lower valuation of finished goods and work-in-progress inventory on the balance sheet compared to absorption costing because fixed manufacturing overhead is excluded from product costs. This²⁵ can present a less comprehensive view of a company's assets.
• Difficulty in Cost Separation: In practice, accurately separating all costs into purely fixed or purely variable components can be challenging, especially for semi-variable costs that have both fixed and variable elements. This²⁴ can introduce subjectivity into the variable costing model.
• Ineffective for Long-Term Pricing Strategies: While useful for short-term pricing decisions, variable costing is less effective for long-term pricing because it does not account for fixed factory overhead as a product cost. Over²³ the long run, a business must cover all its costs, both fixed and variable, to remain solvent and profitable. Relying solely on variable costs for long-term pricing could lead to underpricing products and failing to recover total costs.

As ²²explained by the Corporate Finance Institute, the prohibition of variable costing for external reporting stems from the accounting standards requiring inventory costs to include all expenses to prepare inventory for its intended use, aligning with the matching principle.

²¹Variable Costing vs. Absorption Costing

The fundamental difference between variable costing and absorption costing lies in their treatment of fixed manufacturing overhead costs.

Confusion often arises because both methods calculate product costs, but they do so for different purposes and with different inclusions. While variable costing provides a clearer view of cost behavior for internal operational decisions, absorption costing offers a more comprehensive picture of the total cost of production as required for statutory financial statements.

FAQs

What is the main purpose of variable costing?

The main purpose of variable costing is to assist internal management in decision making, particularly for short-term operational planning, pricing, and profitability analysis. It provides clarity on how costs change with production volume.

⁵, ⁶Why is variable costing not allowed for external reporting?

Variable costing is not allowed for external financial reporting under Generally Accepted Accounting Principles (GAAP) because it does not include all manufacturing costs (specifically fixed manufacturing overhead) in product costs and therefore does not adhere to the matching principle. GAAP requires absorption costing, which accounts for all production costs in inventory and cost of goods sold.

³, ⁴What is a contribution margin in variable costing?

The contribution margin is a key concept in variable costing. It represents the revenue remaining after all variable costs have been covered. This margin is available to cover fixed costs and generate profit. It is essential for break-even analysis and understanding the profitability of individual products or services.

²Can a company use both variable and absorption costing?

Yes, a company can and often does use both variable costing and absorption costing. Variable costing is typically used for internal management reports to aid in operational decisions, while absorption costing is used for preparing external financial statements that comply with accounting standards like GAAP.¹