Variable costing

Definition

Variable costing is an accounting method that assigns only variable manufacturing costs—such as direct materials, direct labor, and variable overhead—to the cost of a product. This approach treats fixed manufacturing costs as period expenses, which means they are expensed in the period they are incurred rather than being allocated to the product. This method is particularly useful for internal decision-making and performance evaluation, allowing for clearer insights into the impact of production volume on overall profitability.

5 Must Know Facts For Your Next Test

1. Variable costing can provide better insights into cost behavior and profitability at different levels of production, making it easier for managers to make informed decisions.
2. Under variable costing, fixed manufacturing costs are not included in product costs, which can lead to different profit reporting compared to absorption costing, especially when inventory levels change.
3. This method is generally not accepted under GAAP for external financial reporting but is widely used for internal purposes and managerial accounting.
4. Variable costing helps in analyzing the contribution margin, enabling companies to understand how much each unit sold contributes to covering fixed costs.
5. In segment disclosures, companies may present variable costing results to provide clearer insights into the performance of different business segments without the distortion caused by fixed cost allocations.

Review Questions

• How does variable costing impact internal decision-making within a company?
  • Variable costing significantly impacts internal decision-making by providing managers with clear insights into how production volume affects overall profitability. By focusing solely on variable costs, managers can analyze the contribution margin more effectively, helping them understand which products are most profitable. This allows for better pricing strategies and resource allocation decisions based on how much each unit sold contributes to covering fixed costs.
• Compare and contrast variable costing with absorption costing regarding their effects on profit reporting and inventory valuation.
  • Variable costing and absorption costing differ fundamentally in how they treat fixed manufacturing costs. Under absorption costing, all manufacturing costs—both fixed and variable—are assigned to products, which can inflate inventory values and affect profit reporting during periods of changing inventory levels. In contrast, variable costing treats fixed costs as period expenses, leading to potentially lower reported profits when inventory increases since those fixed costs aren't allocated to products. This distinction can influence managerial decisions related to pricing and production levels.
• Evaluate how segment disclosures might be influenced by using variable costing instead of absorption costing when reporting financial performance.
  • When using variable costing for segment disclosures, companies can present a more accurate picture of each segment's operational efficiency by focusing on variable costs that directly correlate with production activities. This approach highlights how well each segment covers its own variable costs and contributes to overall profitability without the complications introduced by fixed cost allocations. As a result, stakeholders can make better comparisons between segments and assess performance based on their respective contributions to the company's bottom line.

Related terms

fixed costs: Costs that do not change with the level of production or sales, such as rent and salaries.

absorption costing: An accounting method that allocates all manufacturing costs—both variable and fixed—to the product, affecting inventory valuation and profit reporting.

contribution margin: The difference between sales revenue and variable costs, indicating how much revenue is available to cover fixed costs and contribute to profit.