Variable Costing

Variable costing (also called marginal costing) is a costing method in which fixed manufacturing overheads are not allocated to units produced but are charged completely against revenue in the period in which they are incurred. In variable costing, cost of inventories comprises only of variable manufacturing costs i.e. direct materials, direct labor and variable manufacturing overheads.

Variable costing is based on the contribution-margin approach. Unlike absorption costing, in which fixed manufacturing overhead costs are allocated to each unit produced and reflected in the cost of inventories on balance sheet, in variable costing no fixed manufacturing overhead costs are traced to units.

Variable Costing Income Statement

Variable costing income statement has the following line items:

	Sales
Less	Variable production costs
Less	Variable selling & admin costs
Equals	Contribution margin
Less	Fixed manufacturing overheads
Less	Fixed selling & admin costs
Equals	Net income

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

Example

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

Direct materials	$2,000
Direct labor	3,000
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.

Solution

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

Advantages

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.

by Obaidullah Jan, ACA, CFA and last modified on May 2, 2019

Variable Costing