Variable costing (accounting)

Variable costing, also known as direct costing or marginal costing, is an accounting method in which businesses utilize variable costs directly related to production to determine potential profits. Variable costs fluctuate due to disparities in production volume or sales volume. Examples of variable costs include raw materials, production supplies, and commissions. Variable costs and fixed costs make up a company's total expenses. Fixed costs, or costs that typically remain the same regardless of business activity, include rent, insurance, taxes, and salaries. The generally accepted accounting principles (GAAP), which are rules used by accountants when recording financial transactions, do not recognize variable costing for reporting costs to external sources. GAAP prefers the use of absorption costing, also known as full costing or traditional costing, which takes into account both variable and fixed costs—not just ones directly related to production. Companies mostly use variable costing for internal decision-making purposes.

Background

Variable costs depend on a company's production volume (the amount of goods produced), which means these costs rise when production is up and fall when production decreases. Variable costs include material costs (cost of materials needed to produce the items) and labor costs (how many people are needed to manufacture the goods). If a company sells more of an item, its material costs and labor costs will increase, and when it sells less of an item, the variable costs will decrease.

Companies that use variable costing do not include fixed costs with production costs. The majority of a company's expenses are fixed costs, which are not affected by production levels and depend mostly on operating costs. The amount of goods produced or services sold by a company does not change its fixed costs. For example, a business still has to pay salaries, rent, taxes, and other expenses regardless of how many products it has manufactured and sold each month.

Companies can choose to use either absorption costing or variable costing for accounting purposes. Variable costing typically is utilized to determine potential profits for specific items—regardless of whether they sell. It allows companies to visualize all the costs involved in manufacturing a particular product versus another. However, it has some disadvantages. Because variable costing does not consider a company's total expenses that it has to pay before it makes a profit, using this method sometimes makes it difficult to determine an exact price for particular items. Absorption costing combines all costs associated with manufacturing, including both fixed expenses and those directly related to the production of items. However, while it assigns an amount of fixed expenses per item, this can pre-emptively inflate profits if the item remains in inventory.

Businesses can use variable costing for their own internal accounting purposes, but GAAP requires businesses to use absorption costing when preparing external financial statements. This is because variable costing combines all fixed costs in one lump sum and does not list each individual expense, while absorption costing accounts for all costs.

Overview

Utilizing variable costing allows companies to separate fixed and variable costs, while the use of absorption costing accounts for fixed and variable costs combined. For example, a manufacturing company specializes in making brush heads. It uses $6 worth of materials to produce one brush head, $3 in labor costs, and $2 in variable costs, such as the electricity used to power the machinery. The company's fixed quarterly manufacturing costs (covering rent, taxes, salaries, etc.) is $20,000. If the company produces 5,000 brush heads a quarter, then each brush head costs $11 ($6 + $3 + $2 = $11) under variable costing. Under absorption costing, each brush head costs $15. The fixed manufacturing costs are divided by the number of brush heads produced to get the fixed cost of each brush head ($20,000 / 5,000 brush heads = $4 per brush head). Then the variable cost is added to the fixed cost to obtain the absorption costing ($11 + $4 = $15). If the company produces 8,000 brush heads, its variable costing remains $11, and its absorption costing decreases to $13.50 ($20,000 / 8,000 brush heads = $2.50 per brush head + $11 = $13.50).

Variable costing helps companies determine their cash flow. Using the example above, the manufacturing company produced 5,000 brush heads, but during the quarter, it only sold 4,500 at $20 per brush head. Under variable costing, the company made $90,000 (4,500 x $20 = $90,000) in revenue on the brush heads sold. Its expense reported on the cost of the sold brush heads is $49,500 (4,500 x $11 = $49,500). Its fixed manufacturing costs remain $20,000. The manufacturing profit (revenue minus the cost of the sold brush heads) is $40,500 ($90,000 – $49,500 = $40,500) and its leftover inventory is worth $5,550 (5,000 – 4,500 = 500 x $11 = $5,550). Under absorption costing, revenue is $90,000, and the cost of brush heads sold is $67,500 (4,500 x $15 = $67,500). No separate expense for fixed manufacturing is needed under absorption costing. The manufacturing profit is $67,500 with $7,500 as leftover inventory (500 x $15 = $7,500).

Variable costing helps a company determine how many items must be sold at a particular price before it can break even. The formula used to determine the break-even point is F / (P – V) = BE (fixed costs / [price – variable costs] = break-even point). From the example above, the fixed manufacturing cost is $20,000, the selling price is $20 per brush head, and the variable cost is $11 per brush head. The break-even point is about 2,222 brush heads, or $20,000 / ($20 – $11) = 2,222. Absorption costing cannot be used to help a company determine a break-even point because it combines variable and fixed costs.

Bibliography

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