Variable costing or Direct costing is a costing method that includes only variable manufacturing costs — direct materials, direct labor, and variable manufacturing overhead in the cost of a unit of product. Variable costing is also referred to as direct costing.
Under variable costing, only those costs of production that vary directly with output are treated as product costs. Fixed manufacturing overhead is not treated as product cost under this method.
Rather, it is treated as a period cost and, like selling and administrative expenses, it is charged against revenue in the period it is incurred.
Under variable costing, the cost of production will be as follows:
Cost of production = Direct Materials + Direct labor + Direct Expense + Variable Factory Overhead.
Under variable costing, only those manufacturing costs that vary with output are treated as product costs. This would usually include direct materials, direct labor, and the variable portion of manufacturing overhead.
Fixed manufacturing overhead is not treated as a product cost under this method.
Rather, fixed manufacturing overhead is treated as a period cost, and, like selling and administrative expenses, it is expensed in its entirety each period.
Consequently, the cost of a unit of product in inventory or the cost of goods sold under the variable costing method does not contain any fixed manufacturing overhead cost.
Variable costing is sometimes referred to as direct costing or marginal costing.
Features of Variable Costing
Variable costing has the following features:
- In variable costing, product cost is determined only based on variable manufacturing cost.
- Here, fixed factory overhead is regarded as a period cost and is charged against revenue in the period it is incurred,
- Since fixed factory overhead is not included in the cost of production, the cost of inventory is less as compared with absorption costing.
- Variable costing operating income changes with sales, not with production.
- Contribution Approach is followed in determining net income. Here, the variable cost of goods sold is subtracted from the sales to determine C/M, and all fixed costs are subtracted from C/M to determine net income.
- There is no need to adjust under or over allocation of fixed factory overhead in variable costing as it is not included in the cost of production.
Advantages of Variable Costing
The advantages of variable costing can be summarized as follows:
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.
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.
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 decisions
Variable costing income statements enables management to see and understand the effect that period costs have on profits and facilitates better decision-making.
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.
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 much additional sales.
Disadvantages or Limitations of Variable Costing
Despite all the advantages, we cannot term variable costing flawlessly. It has some limitations/disadvantages which are stated below:
- 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.
- 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.
- Undervaluation of inventory: Under variable .costing, finished goods, and work-inÂprogress 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.
- 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.
- Separation of costs into fixed and variable is a difficult task, especially when such costs are semi-variable.
- No cost is fixed in the long-run.
Difference between Absorption Costing and Variable Costing
| Subjects | Absorption costing | Variable costing |
|---|---|---|
| 1.Definition | Absorption costing is a method of product costing that includes all manufacturing costs- direct materials, direct labor, and both variable and fixed manufacturing overhead in the cost of a unit of product. | It is a costing method that includes only variable manufacturing costs-direct materials, direct labor and variable factory overhead in the cost of a unit of product |
| 2. Computation of cost of production |
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| 3. Fixed factory overhead | Fixed factory overhead is regarded as product cost. | Fixed factory overhead is regarded as a period cost. |
| 4. Value of inventory | Inventory includes all variable cost of production and a portion of fixed factory overhead. As a result, the value of inventory is higher. | Inventory includes the only variable cost of production. As a result, the value of inventory is lower as compared with absorption costing |
| 5. Gross profit and gross C/M | Gross profit is the excess of sales over cost of goods sold. | Gross C/M is the excess of sales over the variable cost of goods sold. |
| 6. Net income | Absorption costing net income changes with production and sales. | Variable costing net income changes with sales, not with production. |
| 7. Utility | Absorption costing is not suitable for managerial decision-making. | Variable costing plays an important role in management decisionÂmaking. |
| 8. Reporting | Absorption costing is required for external reporting. | Variable costing is required for internal reporting. |
| 9. Break-even analysis | It is not useful for break-even analysis | Variable costing is useful in break-even analysis as it provides information on C/M and fixed costs. |
| 10. Variance adjustment | Variable manufacturing cost variance and under or over-allocated fixed factory overhead (volume variance) are adjusted in absorption costing. | Only variable manufacturing cost variances are adjusted in a variable costing. |
Facilities of Variable Costing and the Contribution Approach
As stated earlier, even if the absorption approach is used for external reporting purposes, variable costing, together with the contribution format income statement, is an appealing alternative for internal reports. The advantages of variable costing can be summarized as follows:
- Data required for CVP analysis can be taken directly from a contribution format income statement. These data are not available on a conventional absorption costing income statement.
- Under variable costing, the profit for a period is not affected by changes in inventories. Other things remaining the same (i.e., selling prices, costs, sales mix, etc.), profits move in the same direction as sales when variable costing is used.
- Managers often assume that unit production costs are variable costs. This is a problem under absorption costing since unit product costs are a combination of both fixed and variable costs. Under variable costing, unit product costs do not contain fixed costs.
- The impact of fixed costs on profits is emphasized under the variable costing and contribution approach. The total amount of fixed costs appears explicitly on the income statement, highlighting that the whole amount of fixed costs must be covered for the company to be truly profitable. In contrast, under absorption costing, the fixed costs are mingled together with the variable costs and are buried in the cost of goods sold and ending inventories.
- Variable costing data make it easier to estimate the profitability of products, customers, and other business segments. With absorption costing, profitability is obscured by arbitrarily fixed cost allocations. These issues will be discussed in later chapters.
- Variable costing ties in with cost control methods such as standard costs and flexible budgets, which will be covered in later chapters.
- Variable costing net operating income is closer to net cash flow than absorption costing net operating income. This is particularly important for companies with potential cash flow problems.