Variable costing is a method in which the fixed manufacturing overheads are not allocated to units produced but the whole amount is charged against revenue in the period in which they are incurred. Under variable costing (also called marginal costing), cost of inventories under this method comprises only of variable manufacturing costs i.e. direct materials, direct labor and variable manufacturing overheads.
Unlike absorption costing, in which fixed manufacturing overheads are allocated to each unit produced and reflected in the cost of inventories on balance sheet, in variable costing no fixed manufacturing overheads are traced to units.
Variable costing income statement
Variable costing income statement has the following line items:
|Less||Variable production costs|
|Less||Variable selling & admin costs|
|Less||Fixed manufacturing overheads|
|Less||Fixed selling & admin costs|
Variable production costs include direct materials, direct labor and variable manufacturing overheads.
Contribution margin is the amount contributed by sales towards fixed costs and profit.
Absorption costing vs variable costing
In variable costing, costs are bifurcated into variable and fixed categories regardless of whether they are product costs or period costs, while in absorption costing they are categorized into product costs and period costs regardless of whether they are variable or fixed in nature.
Difference between net income under absorption costing and net income under variable costing arises because in absorption costing fixed manufacturing overheads are included in the cost of inventories and subtracted from revenue for the period in which those inventories are sold, while in variable costing total manufacturing overheads are subtracted in the period in which they are incurred.
Net income under absorption costing can be reconciled with net income under variable costing as follows:
|Absorption costing net income|
|Less||Fixed manufacturing overheads included in closing inventories|
|Add||Fixed manufacturing overheads included in opening inventories|
|Equals||Variable costing net income|
Let's work with the data given in example for absorption costing.
Following information is for XYZ Ltd for the financial year ended 30 March 2015:
|Price per unit||$4.5|
|Units in opening inventories||3,000|
|Units produced during the year||22,000|
|Units in closing inventories||,000|
|Variable manufacturing overheads||1,000|
|Fixed manufacturing overheads||1,500|
|Total cost of opening inventories||7,500|
|Direct materials for the period||$16,100|
|Direct labor for the period||22,000|
|Variable manufacturing overheads for the period||11,000|
|Fixed manufacturing overheads for the period||13,200|
|Total manufacturing cost for the period||62,300|
|Variable selling & administrative expenses for the period||$4,400|
|Fixed selling & administrative expenses for the period||$10,000|
Calculate net income under variable costing.
|Units sold (3,000 + 22,000 - 4,000)||A||21,000|
|Price per unit||B||4.5|
|Total revenue||C = A × B||94500|
|Opening inventories (2,000 + 3,000 + 1,000)||D||6,000|
|Manufactured units (16,100 + 22,000 + 11,000)||E||49,100|
|Closing inventories (49,100/22,000 × 4,000)||F||8,927|
|Variable product costs||G = D + E - F||46,173|
|Variable selling & administrative expenses||H||4,400|
|Total variable costs||I = G + H||50,573|
|Contribution margin||J = C - I||43,927|
|Fixed manufacturing overheads||K||13,200|
|Fixed selling & admin costs||L||10,000|
|Net income||M = J - K - L||20,727|
Variable costing is used for managerial analysis because:
- It categories costs into variable and fixed components which helps in cost-volume-profit analysis.
- It helps in making decisions regarding accepting or rejecting special orders.
- It does not affect net income due to fluctuations in inventory levels.
- It helps in preparing flexible budgets for better variance analysis.
Written by Obaidullah Jan, ACA, CFA <--- Hire me on Upwork