Most business owners would agree that understanding costs is critical for making sound decisions.
Variable costing is an important concept that allows you to analyze the variable costs that change with production volume separately from fixed costs. This gives valuable insights for pricing, production levels, and more.
In this article, we'll define variable costing, walk through examples of variable costs, discuss its importance, explain what goes into the variable cost calculation, and showcase how it assists strategic decision-making for enhanced profitability when compared to absorption costing.
Introduction to Variable Costing in Business and Accounting
Variable costing is an accounting method used in managerial accounting and financial modeling to analyze the profitability of products and services. It classifies costs into variable costs and fixed costs, with only variable production costs included in product costing. This differs from absorption costing which allocates all manufacturing costs, both variable and fixed, to the product cost.
The key benefit of variable costing is that it provides more accurate and detailed cost information to inform pricing and production decisions. By separating fixed and variable costs, managers gain better insight into profit margins and the break-even point.
Understanding Variable Costing Fundamentals
Variable costing, sometimes called direct costing or marginal costing, includes only variable production costs - raw materials, direct labor, commissions, some overhead costs etc. - in determining per unit product costs. Fixed costs like rent, insurance, administrative salaries are excluded.
This means that variable costing income statements will show higher operating income at higher production volumes, since fixed operating costs are treated as period expenses rather than product costs. Inventory valuations are also lower compared to full absorption costing.
The variable cost per unit is calculated as:
Variable cost per unit = Total variable costs / Units produced
Some key benefits of variable costing include:
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More accurate cost data for decision making
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Better calculation of breakeven points and sales mix decisions
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Highlights impact of fixed operating costs on profits
Variable Costing vs Absorption Costing: A Comparative Analysis
Absorption costing allocates both variable and fixed manufacturing costs to units produced. This leads to the following key differences versus variable costing:
Inventory Valuation
Absorption costing values inventory higher as it includes allocated fixed production overheads. Variable costing excludes fixed costs, so values inventory lower.
Income Statement
Absorption income statements generally show lower operating income. Under variable costing, fixed manufacturing costs are treated as an expense in the period incurred rather than capitalized into inventory.
Cost Information
Variable costing provides better insight for decision making around pricing, sales mixes, production volumes etc. Absorption costing can hide impact of fixed costs on profits.
Overall, variable costing gives management more accurate and detailed cost data to improve planning and decisions. But absorption costing is required for external financial reporting. Using both methods provides the best of both worlds.
Practical Application of Variable Costing with Real-World Examples
Let's walk through an example of how variable costing is applied in practice:
A manufacturer produces tables at a budgeted fixed manufacturing overhead of $50,000 per month. Variable production costs are $125 per table. In March, 750 tables were produced and the company sold 700 units.
Under absorption costing, fixed overhead is allocated as follows:
Overhead rate = Fixed Overhead / Budgeted Production
= $50,000 / 1,000 units
= $50 per unit
Total cost per table = $125 + $50 = $175
But under variable costing, fixed overhead is treated as a period expense so product cost only includes the $125 variable cost per table.
This changes operating income as follows:
Sales (700 units x Assume $300 per table) = $210,000
Variable Costs
= Units Sold x Variable cost per unit
= 700 x $125 = $87,500
Contribution Margin = $210,000 - $87,500 = $122,500
Less: Fixed Overhead = $50,000
Operating Income = $72,500
If 1,000 tables were sold instead, variable costing operating income would be $97,500 higher than absorption costing. This shows the production volume impacts on operating leverage.
Variable Costing in Economics: Cost Behavior Analysis
Variable costing plays an important role in basic economic analysis related to production costs and operating leverage, highlighted by the following relationships in cost behavior:
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Total Costs = Fixed Costs + Variable Costs
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Profit = Sales - Variable Costs - Fixed Costs
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Breakeven Point = Fixed Costs / (Selling price per unit – Variable cost per unit)
Understanding how costs behave and impact profit is essential for business strategy and decision making. By classifying costs as fixed or variable, applying techniques like cost-volume-profit analysis, businesses can model financial performance and improve planning.
What do you mean by variable costing?
Variable costing is an accounting method that includes only variable production costs, such as direct materials and direct labor, in the cost of a product. It excludes fixed overhead costs like rent, depreciation, insurance, and management salaries.
The key benefit of variable costing is that it shows the contribution margin per unit sold. The contribution margin is the revenue per unit minus the variable cost per unit. Knowing your contribution margin helps businesses understand:
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Breakeven points - The sales volume needed to cover fixed costs
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Profitability of products - Which products provide the most bottom-line profit
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Impact of decisions - How pricing, product mix etc. affect margins
For example, say your fixed costs are $100,000 per month. You sell two products:
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Product A sells for $10/unit. Its variable cost is $6/unit. So its contribution margin is $4 per unit sold.
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Product B sells for $15/unit. Its variable cost is $7/unit. So its contribution margin is $8 per unit.
If you sell 10,000 units of Product A and 5,000 units of Product B, your total contribution margin is $40,000 from A + $40,000 from B = $80,000. That covers your $100,000 fixed costs and leaves you with a $20,000 total profit.
As you can see, variable costing gives managers key insights into profit drivers. This helps them make decisions to improve profits.
What is an example of a variable cost?
Variable costs are expenses that change in proportion to the activity of a business. Some common examples of variable costs include:
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Raw materials: The cost of materials that go into producing a product typically varies depending on the quantity being produced. The more units a company manufactures, the more raw materials are required.
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Commissions: Commission payments to salespeople are usually based on the dollar value or volume of what they sell. More sales means higher commission expenses.
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Production supplies: Supplies that are consumed in operations, like machine parts, tools, and other items tend to increase as production ramps up.
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Packaging: The materials used to package products for shipping to customers are considered variable costs since more product output necessitates more packaging.
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Delivery costs: Outbound shipping and delivery costs fluctuate relative to sales volume and the frequency of orders needing fulfillment.
In managerial accounting and financial modeling, variable costs play an important role in break-even analysis, contribution margin calculations, budgeting, cost-volume-profit analysis, and more. Tracking which costs are fixed vs. variable is crucial for making sound business decisions.
What is the importance of variable costing?
Variable costing, also known as direct costing, is an important cost accounting method that organizations use to support decision-making and cost-volume-profit (CVP) analysis. Here are some of the key reasons why variable costing is important:
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It separates fixed and variable costs: By treating fixed manufacturing costs as period costs rather than product costs, variable costing allows companies to clearly see the variable costs and margins associated with production decisions. This helps managers understand margins and make better decisions.
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It supports CVP analysis: By separating fixed and variable costs, variable costing provides the information needed (like contribution margin) to easily perform break-even analysis and other CVP modeling. This helps managers understand the impact of volume changes on profits.
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It facilitates pricing decisions: By highlighting the incremental profit contribution of each additional unit sold, variable costing focuses managers on the key drivers of profitability and facilitates better pricing decisions. Products priced based on contribution margin are more likely to be profitable.
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It measures divisional performance: Variable costing enables divisional contribution margins to be easily calculated. This allows performance to be measured and incentives to be set based on the revenues and variable costs that divisional managers can directly control.
In summary, variable costing is a very useful cost accounting technique because it provides relevant information to managers to support decision making related to production, pricing, break-even analysis, and performance measurement. This leads to improved CVP modeling and overall better decisions.
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What goes under variable costing?
Variable costing is an accounting method that includes only variable production costs - direct materials, direct labor, and variable manufacturing overhead - in the cost of a product. It excludes fixed manufacturing overhead costs.
The variable costing formula is:
Variable Product Cost = Direct Materials + Direct Labor + Variable Manufacturing Overhead
Some examples of costs that would be included under variable costing are:
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Direct materials: Ingredients, components, raw materials that go into making the product
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Direct labor: Wages of employees who work directly on production
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Variable manufacturing overhead: Utilities, supplies that vary with production volume
Fixed overhead costs like rent, insurance, and salaries of administrative staff are excluded from product costs under variable costing.
The key benefit of variable costing is that it shows the contribution margin - the amount left over from sales after paying for variable costs. This helps managers understand the impact of increasing or decreasing production volumes on profits.
Overall, variable costing provides useful information for short-term decision making related to production volumes, pricing, and profitability analysis. But it does not assign all manufacturing costs to products, so it does not represent the full cost like absorption costing does.
Decomposing Variable Costs in Business Operations
Variable costs are expenses that change in proportion to production volume. Understanding the components of variable costs empowers businesses to better manage financial outcomes.
Direct Costs: Raw Materials and Labor
Direct costs vary depending on units produced. Key examples include:
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Raw materials: Ingredients, components, supplies used in manufacturing products. More units produced requires more raw materials.
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Direct labor: Wages paid to production workers. More units produced requires more working hours.
As production increases, more raw materials and labor time is needed, driving up the costs of goods sold (COGS). Analyzing how these costs fluctuate aids companies in budgeting and pricing decisions.
Variable Manufacturing Overhead in Production
In manufacturing, overhead refers to indirect costs such as utilities and equipment maintenance. The variable portion increases as production ramps up. Examples include:
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Energy costs to power machinery
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Supplies like lubricants for equipment
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Additional wear and tear on machinery
Tracking variable manufacturing overheads ensures companies know the true cost of increased production capacity. It supports operating leverage analysis - understanding how operating profit reacts to changes in sales volume.
Calculating Commissions as Semi-Variable Costs
Commissions are semi-variable costs, as they increase with sales volume but the rate per unit sold stays fixed. Total commissions can be calculated as:
Total Commissions = Commission Rate x Total Units Sold
The commission rate per unit doesn't change, but as sales volume rises, total commissions increase. This differs from fully variable costs like direct materials that fluctuate per unit.
Breaking Down the Variable Cost Formula
The formula to calculate total variable cost (TVC) is:
TVC = Variable Cost per Unit x Quantity Produced
The key components are:
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Variable cost per unit: The incremental cost of producing one additional unit
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Quantity produced: The number of units manufactured
Multiplying these gives the TVC. This formula is instrumental for companies in forecasting profits across different production scenarios using cost-volume-profit analysis.
Strategic Decision-Making with Variable Costing
Variable costing, also known as direct costing, is an accounting method that separates fixed and variable costs. This allows companies to determine breakeven points, set prices, analyze profitability, and make other strategic decisions.
Determining Breakeven Price Using Variable Costing
Variable costing calculates the breakeven point based only on variable costs, which change with production volume. These include:
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Raw materials
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Direct labor
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Commissions
With variable costing, companies can determine the breakeven price - the price where total sales revenue equals total variable costs. Knowing this helps set competitive pricing while still covering variable expenses.
For example, if variable costs per unit equal $5 and desired profit margin per unit is $2, the breakeven price would be $7. Any price above $7 would contribute towards fixed costs and profits.
Maximizing Contribution Margin for Profitability
The contribution margin measures the profitability of each unit sold. It's calculated by subtracting variable costs from sales price.
Variable costing highlights the contribution margin, allowing companies to determine which products are most profitable. Companies can then shift production to focus on products with higher contribution margins.
For example:
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Product A sells for $10 with variable costs of $7, contributing $3 per unit
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Product B sells for $15 with variable costs of $9, contributing $6 per unit
Here, Product B has a higher contribution margin despite a higher sales price. Variable costing allows companies to identify the most profitable products.
Leveraging Operating Leverage for Financial Gain
Operating leverage measures how revenue growth impacts operating profit. It's highest when a company has high fixed costs and low variable costs.
With high operating leverage, small gains in revenue lead to large gains in operating profit. However, losses are similarly amplified. Variable costing quantifies operating leverage, helping managers evaluate risk vs. reward.
Variable Costing in Break-even Analysis
Break-even analysis identifies the production volume needed to cover total costs. Variable costing simplifies break-even analysis since it only deals with variable costs.
Key break-even metrics are:
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Break-even point in unit sales
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Break-even point in revenue dollars
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Margin of safety
These help managers understand production targets, set sales goals, and mitigate risks. Overall, variable costing is a valuable tool for pricing decisions, profitability analysis, evaluating risk, and cost management.
Comparative Insights: Variable Costing vs Absorption Costing
Variable costing and absorption costing are two different methods of allocating costs for product costing and income statement reporting. The key difference lies in how fixed manufacturing overhead costs are handled.
Fixed Cost Allocation in Absorption Costing
Absorption costing allocates a portion of fixed manufacturing overhead costs to each unit produced, based on the normal capacity for the period. This means that more fixed costs are included in the inventory valuation on the balance sheet. The result is higher net income during periods of production growth and lower net income when production declines.
Variable Costing and Income Statement Presentation
Under variable costing, fixed manufacturing overhead costs are treated as period expenses on the income statement rather than allocating them to units produced. This results in fixed costs being fully deducted in the period they are incurred, rather than shifting a portion of them into inventory. Consequently, net income is higher under variable costing when production outpaces sales, and lower when sales exceed production.
Resolving Absorption and Variable Costing Problems with Solutions
Key problems that can arise in applying absorption and variable costing include:
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Determining the fixed and variable components of manufacturing overhead
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Calculating overhead allocation rates
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Identifying reasons for income statement discrepancies
Careful analysis of cost behavior and activity drivers is needed to accurately separate costs. Numerical examples can demonstrate the different profit impacts. Solutions outline the step-by-step workings to resolve common issues.
Inventory Valuation Differences: Absorption vs Variable Costing
Under absorption costing, fixed manufacturing overhead costs allocated to units produced are included in inventory values on the balance sheet. In contrast, variable costing excludes fixed overhead costs from inventory. This can result in significantly different gross margin and net income figures between the two methods when inventory levels change between periods. Solutions can show the reconciliation of the differences.
Conclusion: Embracing Variable Costing for Enhanced Financial Management
Variable costing can provide businesses with valuable insights for decision-making and optimizing operations. Key benefits include:
Clear Understanding of Profit Drivers
By separating fixed and variable costs, businesses gain clarity on what is truly driving profitability. This helps target the most impactful areas to manage.
Informed Pricing Decisions
Knowing precise variable costs per unit supports setting optimal pricing to achieve profit goals. Businesses can model scenarios to maximize margins.
Focus Resources on Most Profitable Areas
Seeing contribution margins by product line or division allows businesses to spot high and low performers. Resources can shift to products with the best returns.
Confidence in Make vs. Buy Evaluations
Analyzing internal production costs vs. outsourcing supports informed sourcing choices to maximize profitability.
Enhanced Budgeting and Forecasting
Variable costing simplifies and improves projections based on output assumptions rather than arbitrary allocations of fixed expenses.
Embracing variable costing arms businesses with the visibility required to make decisions that drive profitability. While more complex than absorption costing, the precision and insight variable costing offers makes it an invaluable tool for financial management.
