What is Variable Costing?

Variable Costing

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Variable Costing

Variable costing, also known as direct costing or marginal costing, is a costing method where only the variable costs of production are allocated to the manufactured goods. Fixed costs, such as rent, administrative salaries, and other overhead expenses, are treated as period expenses and are not included in the cost of individual products. In other words, fixed costs are expensed in the period in which they are incurred and are not tied to individual units of output.

Components:

In variable costing, the cost of a product or service includes:

Fixed costs are treated separately and are accounted for in the income statement as a whole, rather than being allocated to individual units.

Formula:

In variable costing, the cost of goods sold and ending inventory are calculated based on variable production costs. The formula for cost per unit under variable costing is:

Cost Per Unit (Variable Costing) = Direct Material Cost Per Unit + Direct Labor Cost Per Unit + Variable Overhead Cost Per Unit

Advantages:

Disadvantages:

Example of Variable Costing

Let’s go through an example to illustrate the concept of variable costing in a business setting.

Business Context:

Let’s consider a fictional company called “GadgetPro,” which manufactures wireless earbuds.

Costs and Production:

GadgetPro has the following cost structure for manufacturing one pair of wireless earbuds:

  • Direct Material: $15
  • Direct Labor: $10
  • Variable Overhead: $5

The company also incurs a fixed cost of $20,000 per month for rent, administrative salaries, and other overheads that do not vary with production.

Units Produced and Sold:

For simplicity, let’s say GadgetPro produced 2,000 units and sold 1,800 units in the month of March.

Variable Costing Calculation:

Under variable costing, the cost per unit would include only the variable costs:

Cost Per Unit (Variable Costing) = DirectMaterial + DirectLabor + VariableOverhead

= $15 + $10 + $5

= $30

Income Statement:

Here’s how GadgetPro’s income statement would look like under variable costing for March:

Revenues:

  • Selling Price per Unit: $60
  • Total Revenue (1,800 units sold * $60): $108,000

Cost of Goods Sold (COGS):

  • Cost per unit: $30
  • COGS (1,800 units sold * $30): $54,000

Gross Margin:

  • Gross Margin (Total Revenue – COGS): $54,000

Fixed Costs:

  • Rent, administrative salaries, etc.: $20,000

Net Income:

  • Net Income (Gross Margin – Fixed Costs): $34,000

Business Implications:

By understanding variable costing, GadgetPro can make better-informed decisions that align with its financial goals, especially for short-term scenarios.

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