Variable costing is a cost accounting method that focuses on the costs associated with producing a product or service. This method categorizes costs as either variable or fixed, based on their relationship to the volume of production. Variable costs are expenses that vary directly with changes in production volume, while fixed costs remain constant regardless of production volume.
Variable costing is different from absorption costing, which assigns both fixed and variable costs to each unit of production. Absorption costing can sometimes lead to distorted results, especially when production volumes fluctuate significantly.
Methods of Calculating Variable Costs:
There are different methods of calculating variable costs, depending on the nature of the business and the product or service being produced. Here are some common methods:
- Direct Materials Cost: This is the cost of raw materials used in producing a product. For example, if a manufacturer produces tables, the cost of wood, screws, and varnish are all direct material costs.
- Direct Labor Cost: This is the cost of the labor required to produce a product. For example, if a manufacturer produces tables, the wages paid to workers who cut, assemble, and finish the tables are all direct labor costs.
- Variable Manufacturing Overhead Cost: This is the cost of overhead expenses that vary with production volume, such as electricity, water, and other utilities, production supplies, and equipment maintenance.
- Variable Selling and Administrative Cost: These are the costs associated with selling and promoting a product, such as advertising, sales commissions, and packaging materials.
Advantages of Variable Costing:
- Provides a more accurate picture of the cost of production: Variable costing assigns only the direct costs of producing a product to that product, making it easier to understand the true cost of production. This can be particularly useful in businesses where fixed costs are relatively high and the production volume fluctuates significantly.
- Helps with pricing decisions: Since variable costs are directly proportional to production volume, businesses can use this information to make pricing decisions that ensure profitability. For example, if the variable cost of producing a product is $50, a business could set a selling price of $60 to ensure a profit margin of $10.
- Enables better decision-making: By separating fixed and variable costs, businesses can make more informed decisions about which products or services to offer, which markets to target, and how to allocate resources.
- Facilitates cost control: Variable costing can help businesses control costs by identifying areas where they can reduce variable costs, such as by negotiating lower prices with suppliers, improving production efficiency, or reducing waste.
Disadvantages of Variable Costing:
- Ignores fixed costs: While variable costing provides an accurate picture of the direct costs of production, it does not account for fixed costs, such as rent, salaries, and insurance. This can make it difficult to assess the overall profitability of a business.
- May lead to underinvestment: Since fixed costs are not included in the calculation of product costs, businesses may be discouraged from investing in fixed assets, such as machinery, buildings, or technology, that could lead to increased productivity and profitability.
- Does not comply with GAAP: Generally Accepted Accounting Principles (GAAP) require businesses to use absorption costing for external financial reporting. This means that while businesses may use variable costing for internal management purposes, they must also prepare financial statements using absorption costing for external stakeholders.
Product Mix Decisions:
Variable costing can help businesses make decisions about which products to produce, by analyzing the contribution margin of each product. The contribution margin is the difference between the selling price of a product and its variable costs. By calculating the contribution margin of each product, businesses can determine which products are the most profitable and make decisions about which products to prioritize.
For example, a manufacturer produces two products: Product A and Product B. Product A has a contribution margin of $20, while Product B has a contribution margin of $15. If the manufacturer has limited resources and can only produce one of the products, they would choose to produce Product A, as it generates a higher contribution margin.
Variable costing can also help businesses make decisions about pricing. By understanding the variable costs associated with producing a product, businesses can set prices that ensure profitability. For example, if the variable cost of producing a product is $50, a business could set a selling price of $60 to ensure a profit margin of $10.
Make or Buy Decisions:
Variable costing can be useful in make or buy decisions, which involve deciding whether to produce a product in-house or purchase it from an external supplier. By comparing the variable costs of producing a product in-house with the variable costs of purchasing it from a supplier, businesses can determine which option is more cost-effective.
For example, a manufacturer needs to produce a component for its product. The variable cost of producing the component in-house is $10 per unit, while the variable cost of purchasing it from a supplier is $12 per unit. In this case, it would be more cost-effective to produce the component in-house.
There are several types of variable costs that can be calculated using different formulas. Some common types of variable costs are:
Direct Material Cost:
Direct material cost is the cost of the raw materials used to produce a product. This cost is calculated by multiplying the quantity of raw materials used by the cost per unit.
Direct Material Cost = Quantity of Raw Materials Used x Cost per Unit
Direct Labor Cost:
Direct labor cost is the cost of the labor required to produce a product. This cost is calculated by multiplying the number of hours worked by the labor rate per hour.
Direct Labor Cost = Number of Hours Worked x Labor Rate per Hour
Variable Overhead Cost:
Variable overhead cost is the cost of the expenses that change with the level of production, such as utilities, maintenance, and supplies. This cost is calculated by multiplying the number of units produced by the variable overhead rate per unit.
Variable Overhead Cost = Number of Units Produced x Variable Overhead Rate per Unit
Variable Selling and Administrative Expenses:
Variable selling and administrative expenses are the expenses incurred in selling and marketing a product or service. These expenses are directly proportional to the level of sales and can include sales commissions, advertising costs, and shipping expenses. This cost is calculated by multiplying the level of sales by the variable selling and administrative expenses per unit.
Variable Selling and Administrative Expenses = Level of Sales x Variable Selling and Administrative Expenses per Unit