Definition of Variable Costing
Variable costing refers to all direct cost and variable overhead incurred in the production/manufacturing of a product or rendering of service and excludes all fixed costs. Variable costing focus on all those costs which are directly impacted and affected by a change in production, unlike fixed cost which is static and stationary. Variable costing is frequently used by management to undertaken break-even analysis and determine contribution margin as well. Variable costing is also known as Marginal Costing, Direct Costing, Differential Costing as well as Out of Pocket Costing as well.
A product or service manufactured/delivered by the business has some costs associated with it. These costs are Fixed Costs (which doesn’t change too often) and Variable cost (which are directly affected by the volume of production). Variable costing can be explained simplistically as the study of variable cost components used in the manufacturing of product or service by the business. Variable costing varies with units of production and as such is an ideal costing measure for taking decisions related to the scaling of business, acceptance of new orders, prioritizing products in a portfolio of products by the business.
Features of Variable Costing
- It is easy to compute Variable costing as all costs are easily identifiable.
- Variable Costing can be attributed to units produced and there is a linear relationship between the increase in production and variable costing.
- It provides management with information regarding cost behavior and how it impacts profitability.
- Under Variable Costing all costs are bifurcated into Fixed and Variable and only variable costs are accounted into.
Example of Variable Costing
Let’s understand Variable costing with the help of an example along with its utility.
ABC International has presented the following manufacturing cost incurred in the production of 100000 mobile phones during January 2020:
|Variable expenses per mobile set||$12|
|Fixed Rent Charges of factory||$15,000|
|Fixed Technology charges||$19,000|
|Equipment Charges (fixed)||$28,000|
|Total Manufacturing Cost||$1,442,000|
|Total units manufactured||$100,000|
|Per unit Manufacturing Cost||$14.42|
(Excel sheet attached)
Recently ABC International was approached for special order for manufacturing of 50000 mobile phones for one of its corporate clients. The client offered $ 14 per unit which was rejected by the Costing Head. However, the new CEO insisted that the company should compute its Variable Costing of the product as fixed costs are already incurred and there is already excess capacity available to manufacture the required 50000 units of mobile phones.
Since Variable Costing is focused only on Variable cost factors the per unit variable costing is computed as follows:
For 50000 units all variable costs like Direct Material and Direct Labor will be 50% as the above cost is for 100000 units of mobile phones.
|Direct Material Cost||$65,000.0|
|Total Variable Costing||$690,000.0|
|No of Mobile Units||50000|
|Per Unit Variable Cost||$13.80|
Since Variable Cost is less than the $14 offered to ABC International, it should accept the special order as this will result in a contribution of $0.20 per mobile phone.
Importance of Variable Costing
Variable costing is an indispensable part of Management decision making exercise. These costs are more relevant and require management direct involvement as fixed cost is already incurred and irreversible. It enables making comparisons among profitability of different units within the business more meaningful as it is focused on Variable cost factors and helps in overcoming problems related to the allocation of fixed costs which at times are difficult to bifurcate.
Advantages of Variable Costing
Some of the advantages are given below:
- It helps in focusing on those costs only which are variable and directly impacted by the change in volume of production.
- It helps in undertaking cost volume profit (CVP) Analysis as it allows determining Contribution margin which can be used to identify profitable products and better resource allocation by the business.
- It removes the problem of fixed cost allocation which is quite tedious and at times subjective.
- It helps in better planning of operations by the business and acceptance of orders which exceed the Contribution margin.
- It helps undertake Break-even analysis which is frequently used by business managers.
Disadvantages of Variable Costing
Some of the disadvantages are given below:
- Variable costing misguides management thinking that business can operate profitably at a low contribution margin, as it ignores Fixed cost which also impacts profitability.
- Variable Costing is used only for internal reporting and business has to undertake separate reporting for financial reporting purposes.
- Another challenge with Variable costing is related to the bifurcation of cost into fixed and variable which in some cases is not possible as the certain cost is difficult to be divided into these categories and are semi-variable.
- Another disadvantage with Variable costing is the absence of Economies of scale. Variable cost per unit determined based on Variable costing components does not remain the same as production volume increases; however Variable costing doesn’t capture the same.
Comparison between Variable Costing and Absorption Costing
|Definition||It includes costing of product involving only variable cost.||It includes costing of product involving both Fixed and variable cost.|
|Components of cost||It comprises Direct Material, Direct Labor, Variable overhead, and other direct expense.||It comprises Direct Material, Direct labor, both fixed and variable overhead, and other direct expense.|
|External Internal Reporting||It is required for Internal reporting||It is required for External reporting|
|Estimation of the total cost||It can lead to under measurement of the total cost as it involves only variable cost.||It provides a complete measure of the total cost as well.|
Variable Costing is an important part of product costing and forms part of the internal reporting framework for business. Variable Costing is a useful measure of identifying cost associated with the product in cases where allocating fixed cost is not viable or possible or the management is more interested in knowing the additional cost to be incurred in production without considering fixed cost at all.
This is a guide to Variable Costing. Here we also discuss the definition and example of variable costing along with advantages and disadvantages. You may also have a look at the following articles to learn more –