Variable Costing
A bookkeeping strategy businesses utilize to manage and analyze costs related to their production forms.
What is Variable Costing?
Variable costing, also known as direct or marginal costing, is a bookkeeping strategy businesses utilize to manage and analyze costs related to their production forms.
Unlike absorption costing, which combines variable and fixed manufacturing costs when deciding the cost of goods sold (COGS), variable costing considers variable costs as a portion of COGS. Fixed manufacturing costs are treated as period costs and are not allocated to individual units of production.
Variable costing offers several key concepts and highlights, making it an important apparatus for internal decision-making and performance evaluation.
By confining and crediting variable costs to products or administrations, variable costing gives a more exact representation of how much it costs to create each unit. This may be particularly important in businesses with fluctuating production volumes or complex product lines.
On the other hand, fixed manufacturing costs, such as leases, compensations of permanent workers, and machinery depreciation, are not allocated to products in variable costing. Instead, they are recognized as fixed costs and are subtracted from total income to determine the operating income for the period.
Cost-volume-profit (CVP) analysis is a tool frequently related to variable costing. It helps businesses understand how changes in sales volume will affect their profits.
The contribution margin plays an important part in the CVP examination, enabling decision-makers to make informed decisions with respect to pricing techniques, production levels, and sales strategies.
Key Takeaways
- Businesses utilize the cost accounting technique known as variable costing, often referred to as direct or marginal costing, to assign and track costs related to producing goods or services.
- Variable costing essentially focuses on assigning and tracking variable manufacturing costs to products or services.
- Unlike absorption costing, which treats fixed manufacturing costs as product costs, variable costing treats fixed manufacturing costs as period costs.
- Variable costing is utilized for internal administration purposes and may not comply with external money-related announcing necessities, which ordinarily depend on assimilation costing.
Variable Cost Formula
The Variable Cost Formula is a crucial tool in cost analysis, helping businesses determine the variable costs associated with producing a specific quantity of goods or providing a certain level of services.
Here's the equation for variable costs:
Variable Cost = Variable Cost per Unit x Number of Units
Where,
1. Variable Cost per Unit
It represents the variable manufacturing cost incurred for each unit produced or for each unit of service provided. It's essentially the cost that varies with changes in production or activity levels.
2. Number of Units
This refers to the quantity of goods manufactured or the level of service provided. It's the measure of production or activity to which variable costs are linked. To utilize this equation, you must determine the variable cost per unit (VCU).
Once you have the VCU, you can calculate the total variable costs for various production or activity levels by multiplying it by the number of units.
How To Calculate Variable Cost
Variable costing focuses on calculating the costs that vary with changes in production levels. Here are the steps to calculate variable costing.
1. Identify Variable Costs
Determine which costs exhibit variability with changes in production levels. Common examples include:
- Direct material: The cost of material utilized to manufacture a product
- Direct labor: The cost of labor directly included within the production process
- Variable manufacturing overhead: Includes overhead costs that vary with production levels, such as utilities, supplies, and maintenance expenses directly related to production.
2. Calculate Variable Cost per Unit
For each variable cost category, calculate the variable cost per unit. To do this, divide the total variable cost for that category by the number of units produced.
Variable Cost per Unit (VCU) = Total Variable Cost / Number of Units Produced
3. Determine Total Variable Costs
Once you've got the VCU for each variable cost category, calculate the total variable costs for a particular production level by multiplying the VCUs by the number of units or the activity level.
Total Variable Costs = (VCU for Direct Materials x Number of Units) + (VCU for Direct Labor x Number of Units) + (VCU for Variable Manufacturing Overhead x Number of Units)
4. Compute Contribution Margin
The contribution margin represents the sum of income that remains after covering variable costs. It is calculated by subtracting the total variable costs from total sales revenue.
Contribution Margin = Total Sales Revenue - Total Variable Costs
5. Utilize Variable Costing for Decision-Making
Once you have calculated variable costs and contribution margin, you can utilize this data for different decision-making processes, such as estimating techniques, cost control measures, cost-volume-profit (CVP) analysis, and surveying the effect of changes in production levels on profitability.
Example of Variable Costing
Given Information
- Variable cost of manufacturing per widget: $5 (including direct materials, direct labor, and variable manufacturing overhead).
- Widgets’ Selling Price: $10 each
- Monthly fixed expenditures for manufacturing: $10,000
- Units of widgets produced and sold monthly: 2,000
Calculations
1. Total Variable Manufacturing Costs
Number of Produced Units x Variable Cost per Unit
$5 x 2,000 = $10,000
2. Total fixed manufacturing costs (which are regarded as one-time costs)
Fixed Manufacturing Costs = $10,000
3. Total sales revenue
Sales Price per Unit x The Total Number of Sold Units
$10 x 2,000 = $20,000
4. Contribution Margin
Contribution Margin = Total Sales Revenue - Total Variable Costs
Contribution Margin = $20,000 (Total Sales Revenue) - $10,000 (Total Variable Manufacturing Costs)
Contribution Margin = $10,000
Implication: The amount can be used to cover the fixed manufacturing costs of $10,000, leaving no profit. This means that the full contribution margin is utilized to cover the fixed manufacturing costs in this scenario.
The variable costing approach helps businesses understand how their variable costs and contribution margin contribute to covering their fixed costs and profitability.
Challenges of Variable Costing
Variable costing has its share of challenges and impediments that ought to be considered when implementing this accounting strategy.
Here are a few of the key challenges and restrictions:
1. Inaccurate for External Reporting
One of the essential limitations of variable costing is that it does not comply with Generally Accepted Accounting Principles (GAAP) for external financial reporting or financial statements.
Most financial statements, such as income statements and balance sheets, require the utilization of absorption costing, which includes variable and fixed manufacturing costs within the cost of goods sold.
2. Fixed Costs are Treated as Period Costs
In variable costing, fixed manufacturing costs are considered period costs and are not allocated to individual units created. This may lead to a mismatch between costs and income within the salary statement, particularly if production levels vary significantly. It may not accurately represent the cost of producing each unit.
3. Difficulty in Matching Costs with Revenue
Variable costing can make it challenging to match costs with income precisely because it does not allocate fixed manufacturing costs to products. This may result in a distortion of profit figures, particularly if fixed costs are significant.
4. Complex Cost Allocation
For businesses with complex product lines or different cost centers, allocating variable costs precisely to specific products or ventures can be challenging. Determining which costs are truly variable and which are settled can be a complex assignment in a few cases.
5. Not Suitable for Long-Term Decision-Making
Variable costing focuses more on short-term decision-making because it avoids fixed manufacturing costs. For long-term strategic decisions, absorption costing may give a more accurate picture of overall costs and productivity.
Variable Costing vs. Absorption Costing
The firm's specific needs, objectives, and reporting needs should guide the decision between variable costing and absorption costing. Many businesses employ both techniques to grasp their cost structures and profitability for various reasons fully.
For your convenience, the following table compares variable costing and absorption costing:
| Particulars | Variable Costing | Absorption Costing |
|---|---|---|
| Managing Variable Costs | It includes variable manufacturing expenses in COGS, such as direct labor costs, direct material costs, and variable manufacturing overhead. | It includes direct materials, direct labor, variable manufacturing overhead, and fixed manufacturing overhead costs in COGS. |
| Managing Fixed Costs | Fixed production costs are not allocated to products; they are treated as period expenses. | Based on output levels, it allocates fixed manufacturing expenses to products. |
| Revenue Statement | Shows the contribution margin (sales revenue minus variable costs) clearly. | COGS is increased as a result of including variable and fixed production expenses. |
| Revenue Reporting | Profits may fluctuate with output levels, making it susceptible to changes in activity. | Since fixed manufacturing costs are distributed over all units produced, profits are less vulnerable to changes in production levels. |
| Typical Use Cases | Excellent for cost analysis, internal management reporting, quick decisions, doing a cost-volume-profit (CVP) analysis, and comprehending how changes in production affect profitability. | It is required for Generally Accepted Accounting Principles (GAAP)-compliant external financial reporting, useful for making long-term decisions and reporting financial data. |
Variable Costing FAQs
A cost accounting technique called variable costing allots solely variable production costs to goods or services. The cost of goods sold (COGS) does not include fixed production costs as they are treated as period expenses.
Costs that vary directly in response to shifts in production or sales levels are known as variable costs. They typically consist of variable production overhead, direct materials, and direct labor.
The way fixed production expenses are handled is the fundamental distinction. While absorption costing allocates both variable and fixed manufacturing costs to goods, variable costing treats fixed manufacturing costs as period expenses.
Variable costing contribution margin, also known as the contribution margin ratio, is a financial metric used to assess the profitability of a product, service, or business segment. It represents the revenue remaining after covering all variable costs associated with producing or providing a product or service.
or Want to Sign up with your social account?