Variable costing is a managerial accounting cost concept. Under this method, manufacturing overhead is incurred in the period that a product is produced. This addresses the issue of absorption costing that allows income to rise as production rises. Under an absorption cost method, management can push forward costs to the next period when products are sold. This artificially inflates profits in the period of production by incurring less cost than would be incurred under a variable costing system. Variable costing is generally not used for external reporting purposes. Under the Tax Reform Act of 1986, income statements must use absorption costing to comply with GAAP.
Variable costing is a costing method that includes only variable manufacturing costs direct materials, direct labor, and variable manufacturing overhead in unit product costs.
Variable Costing in Financial Reporting
Although accounting frameworks such as GAAP and IFRS prohibit the use of variable costing in financial reporting, this costing method is commonly used by managers to:
- Conduct break-even analysis to determine the number of units needed to be sold to begin earning a profit.
- Determine the contribution margin on a product, which helps to understand the relationship between cost, volume, and profit.
- Facilitate decision-making by excluding fixed manufacturing overhead costs, which can create problems due to how fixed costs are allocated to each product.
Uses of Variable Costing
Variable costing is quite commonly used by management to assist with a variety of decisions. For example, one might conduct a breakeven analysis to determine the sales level at which a business earns a zero profit. Another possibility is to use it to establish the lowest possible price at which a product can be sold. Yet another use is to formulate internal financial statements into a contribution margin format (which must be adjusted before they can be issued to outside parties).
Variable costing formula = (Direct Labor Cost + Direct Raw Material Cost + Variable Manufacturing Overhead)/Number of Units Produced.
Steps to Calculate Variable Costing
- Firstly, direct labor cost is directly attributed to production. The direct labor cost is derived according to the rate, level of expertise, and the number of hours employed for the production. Nevertheless, the cost can be extracted from the income statement.
- Secondly, one has to identify the type of material required and then the amount of material to be used in the production of each unit to determine the unit price of those materials. However, the direct raw material cost can also be extracted from the income statement.
- Thirdly, identify the other remaining variable part of the manufacturing overheads from the income statement.
- Now, determine the most crucial part of the formula, which is the number of units that have been produced from the production details annexed with the annual report.
- Finally, add up direct labor cost, direct raw material cost, and variable manufacturing overhead and divide the sum by the number of units produced.
Advantages of Variable Costing
- Cost-volume-profit analysis
Income statements under variable costing give data relating to “Gross contribution margin,” “Contribution margin,” and “Total fixed costs.” These data can easily be used in the c-v-p analysis.
- Operations planning
Variable costing can readily supply data on variable costs and contribution margin, which management needs each day to make decisions relating to special order, expansion of capacity, shut-down of production, etc.
- Product pricing
The variable cost of production is considered at the time of fixing the selling price for a special order. Variable costing can readily supply data relating to the variable cost of production.
- Management control
The reports based on variable costing are far more effective for management control than those based on absorption costing because;
- Variable costing reports are related to profit objectives,
- It can pinpoint responsibility according to organizational lines.
- Cost control
Cost control becomes easier because only variable manufacturing costs are considered.
- Management decisions
Variable costing income statements enables management to see and understand the effect that period costs have on profits and facilitates better decision-making.
- Change in profit
Variable costing net income changes with sales. As a result, it becomes easily understandable as to how much additional profit will be earned from how many additional sales.
Disadvantages or Limitations of Variable Costing
- Long-term pricing: Variable costing is not useful for long-term pricing policy simply because it does not consider fixed factory overhead as product cost.
- Inaccurate cost: Directly identifiable fixed cost is specifically related to production. But all fixed costs are treated as a period cost. As a result, the cost of production may not be accurate.
- Undervaluation of inventory: Under variable costing, finished goods, and work-in progress are undervalued. This is because of the non-inclusion of fixed factory overhead in product cost. As a result, the balance sheet does not represent a true and fair view.
- Separation of costs into fixed and variable is a difficult task, especially when such costs are semi-variable.
- External reporting and tax reporting: Variable costing is not acceptable for external reporting and tax reporting until today. It is only applicable to internal management. It does not conform to GAAP.
- No cost is fixed in the long-run.