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Variable Costing

Overview On Variable Costing

Variable costs are costs which vary with changes in production activities in a business.

They are defined as the summation of marginal costs over all the goods produced and encompass costs which are directly associated with production activities. Variable costs are also referred to as unit costs as they change with changes in the number of units produced by a business. They are directly proportional to production.

Variable costing is a methodology deployed in internal reporting and analysis of a business. It is not required under the accounting frameworks and guidelines such as Generally Accepted Accounting Principles and International Financial Reporting Standards to prepare and report financials under the variable costing method. Under these principles all costs are assigned to the good produced.

Variable costing requires only variable costs to be assigned to the inventory. There are primarily two costing methods used in accounting which are direct / variable costing and absorption or full costing methodologies. The difference in the approach lie in assignment of fixed overhead costs related to manufacturing. Under the absorption costing method, fixed overhead costs related to manufacturing are accounted for when the goods are sold whereas under variable costing, the same costs are accounted for when they are actually incurred. Thus under variable costing, all the overhead costs are accounted for under expenses during the period which they are incurred and direct raw material costs and variable overhead costs are assigned to the good produced.

Under variable costing system, variable or unit costs encompass direct materials, direct labour and that portion of manufacturing overheads which are variable in nature. The remaining portion of fixed manufacturing cost is not considered under variable costing. They are treated at par with selling and administrative expenses. They are accounted for in totality against revenues. Notably selling and administrative expenses are never assigned to cost of production irrespective of the costing methodology deployed.

Managers and financial officers prepare variable costing statements to understand the following about their businesses:

  • Arrive at the breakeven point that is to understand how much needs to be produced to reach a no profit no loss situation.
  • Determine the lowest possible cost at which a product can be sold

Students often find it difficult to understand how to classify costs and allocate them appropriately based on the costing method. It takes time for them to correctly prepare variable costing statements. Let us look at a simple calculation of variable costing

Following are the financials of ABC Company

Number of units produced          = 7,000

Variable Costs

Direct materials =             USD 3

Direct labour = USD 5

Variable manufacturing overhead = USD 2

Variable selling and Administrative expenses = USD 3

Fixed costs per year:

Fixed manufacturing overhead                                  USD 35,000

Fixed selling and administrative expenses            USD 15,000

Unit product Cost under the Variable Costing Method will be calculated as

Direct materials                                                                              USD 3

Direct labour                                                                      USD 5

Variable manufacturing overhead                            USD 2

Unit product cost                                                             USD 10

Fixed manufacturing overhead of USD 35,000 will be charged against total income. From this it can be understood that USD 10 will be considered as the cost of goods sold.

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