What is Variable Costing?
Variable costing is 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. It is also often referred to as unit level cost.
Raw materials, labor, and commissions might be few examples of the costs incurred by an organization. Their costs depend on the amount of output. It is the contrary scenario from fixed costs where, those costs would be incurred irrespective of the output of the organization. Organizations use variable costing calculator to determine profitability of the product.
Table of contents
- Variable costing is a financial metric used to understand production costs using only variable costs.
- The formula for calculating includes costs such as direct labor, overheads, and direct material costs, which are then divided by the total number of units produced.
- Variable costing helps businesses evaluate the contribution margins of the business so that a break-even analysis can be concluded. Through this, the business decides the total number of units to be produced to help them earn profits.
- Variable costs do not include the absorption or the fixed costs of a business; therefore, that portion of the costing is excluded from the computation of the production costs.
Variable Costing Explained
Variable cost or unit-level cost is a method of cost accounting which accounts the costs of production directly vary with the output. Fixed manufacturing costs are not considered for variable costing accounting.
It helps a company to determine 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 this 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 accounting 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 Labor Cost + Direct Raw Material Cost + Variable Manufacturing Overhead)/Number of Units Produced.
How To Calculate?
The variable costing calculator can be used by following the steps as discussed below.
The variable costing formula can be calculated in the following five steps:
- Firstly, direct labor cost is directly attributed to production. The direct labor cost is derived according to the rate, level of expertise, 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 overheads 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 divide the sum by the number of units produced.
Let us discuss a few simples to advanced examples to understand the variable costing accounting in detail
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 the financial director of the company has vetted:
- 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 (overheads) per unit of cloth = $4
Therefore, Variable costing formula= Raw material per unit of cloth + Labor cost per unit of cloth + Other direct costs (overheads) per unit of cloth
- = $10 + $6 + $4
- = $20 per unit of cloth
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 + Labor cost + Utilities (overheads)) ÷ 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 cost is lower than the pricing offered in the contract, which means that the order can be accepted.
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.
Using the above-given data, we will first calculate calculate the total variable cost Calculate The Total Variable CostTotal variable cost is the total of all variable costs that would change in proportion to the output or the production of units and helps analyze the company's overall costing and profitability. Total variable cost formula = number of units produced x variable cost per unit..
In the below given excel template, we have used the calculation to find the chocolate factory’s Variable Costing.
Variable Costing Vs Absorption Costing
The costs of production are always a factor that businesses want to perfect as this factor ultimately decides profitability and their overall growth in the market. Both variable and absorption are factors that are often misunderstood for one another. However, it is important to understand the differences between the two.
Let us understand why businesses use both absorption and variable costing calculator through the discussion below.
- Variable costing considers only direct expenses incurred for production of a product. It is also often called as direct costing.
- They are often used for internal reporting. Managerial decisions are made based on the costs incurred at the production level and management always wants to make sure that variable costs are minimized as much as possible.
- Variable cost accounting involves only variable production costs to be tied to inventory, cost of goods sold, and work-in-progress.
- It calculates the difference between sales and variable cost of sales to derive the amount.
- Absorption cost includes both variable and fixed costs of production. It is also called full costing.
- Absorption costing is used for external stakeholder and even for filing taxes. It is in accordance with Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS).
- It is based on the external reporting standards set by external organizations such as government agencies and regulatory bodies.
- It includes all costs of production and work-in-progress inventories.
- Absorption costing is used to determine the net profit of an organization.
Frequently Asked Questions (FAQs)
Variable costing is important because it assists the managers in comprehending a better contribution margin income statement, which further helps them to accumulate a much-deeper cost-profit-volume analysis.
Variable costing helps businesses plan better managerial authorities, cost control, and direct analysis of each additional cost incurred in manufacturing. Also, it assists them in making sensible pricing decisions.
Absorption costing includes the fixed costs associated with the number of total goods produced, whereas variable costs include the direct expenses incurred in the goods sold, excluding the fixed overhead expenses.
This article has guided to what is Variable Costing. Here we discuss its examples, how to calculate, formula, and compared it with absorption costing. You can learn more about Financial Analysis from the following articles –