ACC2236 - Variable Costing

Variable costing

Variable costing is a methodology that only assigns variable costs to inventory. This approach means that all overhead costs are charged to expense in the period incurred, while direct materials and variable overhead costs are assigned to inventory. There are no uses for variable costing in financial reporting, since the accounting frameworks (such as GAAP and IFRS) require that overhead also be allocated to inventory. Consequently, this methodology is only used for internal reporting purposes. However, it is quite commonly used in this role, where variable costs are used to:

• Conduct breakeven analysis to determine the sales level at which a business earns a zero profit.
• Establish the lowest possible cost at which a product can be sold.
• Formulate internal financial statements into a contribution margin format (which must be adjusted before they can be issued to outside parties).

When variable costing is used, the gross margin reported from a revenue-generating transaction is higher than under an absorption costingsystem, since no overhead allocation is charged to the sale. Though this does mean that the reported gross margin is higher, it does not mean that net profits are higher - the overhead is charged to expense lower in the income statement instead. However, this is only the case when the level of production matches sales. If production exceeds sales, absorption costing will result in a higher level of profitability, since some of the allocated overhead will reside in the inventory asset, rather than being charged to expense in the period. The reverse situation occurs when sales exceed production.

Example

Mark works as an accountant at a leading manufacturing company that produces equipment for pediatric private practice. He is asked to calculate the operating income using the direct costing and the absorption costing methods and compare them. Under the direct costing method, Mark calculates the variable cost of goods sold at 50% of sales to find the product margin, and he deducts the variable expenses to find the contribution margin.

Hence, the fixed manufacturing overheads are allocated against sales during the period in which they are incurred. Also, variable costs comprise of direct materials, direct labor, and variable manufacturing overheads. After deducting the fixed costs from the contribution margin, Mark finds that the company’s operating income is $100,000.

Under the absorption costing method, Mark calculates the cost of goods sold at 70% of sales to find the gross margin, and he deducts the operating expenses (which are the sum of variable expenses and fixed expenses under the indirect costing method), to find that the company’s operating income is $100,000.

Hence, with both methods, he arrives at the same conclusion, but the difference is in the way each method allocates the fixed manufacturing overheads on the income statement.

Summary Definition

Define Variable Costing: Variable costing means a method of accounting for production expenses where all variable costs are included in the product cost during the period.

taken from: https://www.myaccountingcourse.com/accounting-dictionary/variable-costing