What is Variable Costing?
Variable costing is defined as a cost accounting method for calculating production expenses where only variable costs are included in the product cost. The formula of variable costing only considers the direct cost and other variable manufacturing expenses incurred on each product unit.
Variable Costing Formula
Variable Costing is calculated as the sum of direct labor cost, direct raw material cost, and variable manufacturing overhead divided by the total number of units produced.
Variable Costing Formula = (Direct Labour Cost + Direct Raw Material Cost + Variable Manufacturing Overhead)/Number of Units Produced
Steps to Calculate Variable Costing
The variable costing formula can be calculated in the following five steps:
- Firstly, direct labor cost directly attributes to production. The direct labor cost is derived according to the rate, level of expertise of the labor, and the number of hours employed for the production. Nevertheless, the cost can be extracted from the income statement.
- Secondly, one has to identify the type of material required and then the amount of material to be used in the production of each unit to determine the unit price of those materials. However, the direct raw material cost can also be extracted from the income statement.
- Thirdly, identify the other remaining variable part of the manufacturing overheadsManufacturing OverheadsManufacturing Overhead is the total of all the indirect costs involved in manufacturing a product like Property Tax on the production premise, Remunerations of maintenance personnel, Rent of the manufacturing building, etc. Manufacturing Overhead is the total of all the indirect costs involved in manufacturing a product like Property Tax on the production premise, Remunerations of maintenance personnel, Rent of the manufacturing building, etc. Manufacturing Overhead is the total of all the indirect costs involved in manufacturing a product like Property Tax on the production premise, Remunerations of maintenance personnel, Rent of the manufacturing building, etc. from the income statement.
- Now, determine the most crucial part of the formula, which is the number of units that have been produced from the production details annexed with the annual report.
- Finally, add up direct labor cost, direct raw material cost, and variable manufacturing overhead and then divide the sum with the number of units produced.
Examples of Variable Costing
Let’s take a few simples to advanced examples to understand the concept in detail –
Let us assume that XYZ Limited is a company that manufactures clothes for people of the elite class living in the modern city. The managerial accountant provides the following data, which has been vetted by the financial director of the company that:
- Raw material per unit of cloth = $10
- Labor cost per unit of cloth = $6
- Fixed cost in total for the period = $500,000 (redundant)
- Salary for Sales team for the period = $250,000 (redundant)
- Other direct costs (variable overhead) per unit of cloth = $4
Therefore, Variable costing formula= Raw material per unit of cloth + Labour cost per unit of cloth + Other direct costs (variable overhead) per unit of cloth
- = $10 + $6 + $4
- = $20 per unit of cloth
Let us assume ABC Limited is a manufacturer of mobile phone covers. The company currently has received an order for 1,000,000 mobile covers at a total contract price of $350,000. However, the company is not sure whether the order is a profitable proposition. The following are the excerpts from the entity’s income statement for the calendar year ending in December 2017:
- Raw material = $300,000
- Labour cost = $150,000
- Machinery = $100,000
- Insurance = $50,000
- Equipment = $100,000
- Utilities (fixed overhead) = $40,000
- Utilities (variable overhead) = $150,000
- Number of mobile covers produced = 2,000,000
Now, based on the above information calculation will be,
- Variable costing formula= (Raw material + Labour cost + Utilities (variable overhead)) ÷ Number of mobile covers produced
- = ($300,000 + $150,000 + $150,000) ÷ 2,000,000
- = $0.30 per mobile case
- As per the contract pricing, the per unit price = $350,000 / 1,000,000 = $0.35 per mobile case
Therefore, the costing is lower than the pricing offered in the contract, which means that the order should be accepted.
Relevance and Use
It helps a company in the determination of the contribution marginContribution MarginThe contribution margin is a metric that shows how much a company's net sales contribute to fixed expenses and net profit after covering the variable expenses. As a result, we deduct the total variable expenses from the net sales when computing the contribution. of a product, which eventually aids the break-even analysis that can be conducted to fix the number of units needed to be sold to book a profit.
Further, the application of variable costing in the production and sales of additional units can add to a company’s bottom line in terms of profit because the units would not cost the company any additional fixed cost to produce. Variable costing excludes fixed or absorption costs, and hence profit is most likely to increase owing to the money made through the sale of the additional items.
Variable Costing Calculation (with excel template)
Let us assume that PQR is a chocolate factory and has the costs, sales, and production information as per the below template.
In the below-given template is the data of the chocolate factory.
By using the above-given data, we will first calculate the total variable cost.
So the calculation will be-
In the below given excel template, we have used the calculation to find the chocolate factory’s Variable Costing.
So the Calculation will be:-
This article has been a guide to what is Variable Costing and its definition. Here we discuss the formula of Variable Costing along with step by step calculation examples. You can learn more about Financial Analysis from the following articles –