Variable Costing: What Is, How to Calculate, and Advantages

Variable costing and absorption costing are the most common ways to figure out production costs. There are three main stages in a business: production, distribution, and sales, especially selling to customers.

Both absorption costing and variable costing help businesses calculate the cost of a product, which makes them important in business. To easily calculate using these methods, you can use HashMicro Accounting Software.

This system will automatically calculate both cost types, making it madali lang gamitin for accountants. It also gives accurate, real-time financial reports.

To succeed, a company must boost profits and reduce losses. There are two ways to calculate production costs: total costs and variable costs. Below, you’ll find definitions, strengths, and variable cost examples.

What is Variable Costing?

Variable costing is an accounting method that includes only variable production costs like materials, labor, and overhead in the cost of goods sold. It helps businesses assess how changes in production volume affect profitability by excluding fixed costs from the calculation.

Variable Costing vs Absorption Costing

Variable costing and absorption costing are two distinct methods for handling production costs in accounting. The key difference lies in how they treat fixed manufacturing costs.

Key Differences:

• Fixed Costs Treatment: In variable costing, fixed manufacturing costs are excluded from the cost of goods sold, while in absorption costing, fixed costs are included in product costs.
• Profitability Impact: Variable costing gives a more direct view of how changes in production volume impact profitability, while absorption costing may inflate profitability when inventories increase.
• External Reporting: Absorption costing is required for external reporting under GAAP, whereas variable costing is typically used for internal decision-making.

The Function of Variable Costing

Variable costing helps management make short-term decisions by:

• Letting them know the contribution margin to plan profits through cost-volume-profit analysis and guide short-term policies.
• Making it easier to monitor operations, assess performance, and ensure accountability across departments.
• Providing insights to control costs effectively by focusing on variable expenses.
• Helping in determining the best product pricing strategy for higher profitability.
• Simplifying budget comparisons by focusing only on relevant variable costs.

For a better understanding of variable costing and how to simplify it, read our article on the accounting system to discover how to automate calculations and improve cost management.

The Advantages of Variable Costing and Absorption Costing

If you’re still unsure about picking the right method for your business, the rest of this article will help you gain more understanding to make the best decision.

The advantages of variable costing

• Operations planning
  Variable costing helps managers by showing only the costs that change with production. This data helps them decide whether to accept special orders, expand production capacity, or stop producing certain items when necessary.
• CVO analysis
  Variable costing income statements clearly separate the contribution margin (sales minus variable costs) and fixed costs. This makes it easier to use cost-volume-profit (CVP) analysis, helping businesses see how changes in sales volume impact profits.
• Product costs
  When calculating prices for special or custom orders, variable costing gives a quick and accurate view of the direct costs involved in producing those items. This helps businesses set fair and competitive prices.
• Management decisions
  Variable costing income statements break down costs in a way that helps managers understand how certain expenses (like fixed costs) affect overall profits. This clarity supports better decision-making for the company.
• Management control
  Since variable cost reports directly link profit goals to costs, they help managers better control operations. These reports show who is responsible for different areas and make it easier to track performance against goals.
• Budgeting
  By focusing only on variable costs in production, variable costing makes it simpler for manufacturers to control costs. This approach reduces the complexity of managing budgets and improves overall cost efficiency.
• Profit change
  With variable costing, it’s easier to see how sales directly affect profits. When sales increase, businesses can clearly see how much extra profit they will earn, as only variable costs rise with more sales, while fixed costs remain constant.

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The advantages of absorption costing

• More Accurate Production Costs: absorption costing includes all overhead costs like rent, utilities, and salaries, giving a clearer picture of the true cost to produce a product. By considering every expense involved in production, businesses can make better pricing and budgeting decisions.
• Higher Inventory Levels: absorption costing assigns fixed costs (like factory rent or machinery depreciation) to each product. These costs stay attached to the product until it’s sold. As a result, products in inventory appear to have higher costs, which inflates the value of the company’s stock.
• Increased Operating Profit and Net Income: With absorption costing, fixed overheads are only recorded as expenses when the product is sold. This means if a product remains unsold, those costs stay in inventory and don’t immediately affect profit. 

The Disadvantages of Absorption Costing and Variable Costing

Before deciding between absorption costing and variable costing, it’s important to consider their limitations. Each method has its drawbacks that can affect financial reporting and decision-making. Let’s review the disadvantages of both.

The disadvantages of variable costing

Variable costing has some limitations despite its benefits:

• Inaccurate cost: Fixed costs tied to production are treated as period costs, leading to inaccurate production costs.
• Long-term pricing: It doesn’t factor in fixed factory overhead, making it unsuitable for long-term pricing.
• Inventory undervaluation: Finished goods and work-in-progress are undervalued due to the exclusion of fixed overhead from product costs, resulting in an inaccurate balance sheet.
• External and tax reporting: Variable costing isn’t accepted for external and tax reporting as it doesn’t align with GAAP.
• Difficult cost separation: It’s hard to distinguish between fixed and variable costs, especially with semi-variable costs.

The disadvantages of the absorption costing

absorption costing is not ideal because managers often need incremental costs (indirect costing) or the bottleneck capacity a cost object uses. Here are some issues with absorption costing:

• Pricing: When sales set product prices above full cost, the result can be overpriced products, especially when competitors base pricing on direct costs.
• Fraud: A person could boost production and delay overhead costs, creating false short-term profits by keeping units in inventory.
• Allocation: Overhead costs aren’t directly traceable to cost objects, so assigning them can lead to inflated costs. Activity-based costing offers a more accurate solution to this issue.

Example of Variable Costing

JDN, a phone case manufacturer, shared parts of its income statement for 2024. In 2024, the company produced 1,000,000 phone cases with total manufacturing costs of ₱33,700,000 (around ₱33.70 per phone case). Recently, they received a special order for 1,000,000 phone cases at a total cost of ₱22,500,000.

Although the company has enough production capacity, the manager hesitates to accept the special order because it is lower than the ₱33,700,000 manufacturing cost stated in their financial report. As the company’s cost accountant, the manager asks for your input on whether to accept the order.

It’s important to note that the ₱33,700,000 includes fixed costs like insurance, equipment, and utilities. Variable costing should be used to evaluate the special order.

Direct materials cost ₱8,325,000, direct labor is ₱4,162,500, and variable overhead is ₱4,440,000. Total variable costs amount to ₱16,927,500 for 1,000,000 units, which equals ₱16.93 per phone case.

To produce the special order of 1,000,000 cases, the total variable cost is ₱16,930,000. Thus, the contribution margin is ₱22,500,000 – ₱16,930,000 = ₱5,570,000.

The company should accept the special order based on the variable costing formula, as it will increase profits by ₱5,570,000.

The manager’s hesitation stemmed from mistakenly including fixed costs in the calculation. Since the company has enough capacity, there won’t be additional fixed costs for producing the extra 1,000,000 units. This shows how important variable costing is for decision-making.

Automate Variable Cost Calculation with HashMicro

Tracking variable costs is crucial for managing production efficiently. Features like profit & loss vs budget & forecast and budget & realization help you compare actual spending with your budget. With HashMicro, this process becomes easier, giving you clear insights to boost your profits.

HashMicro’s Accounting Software goes beyond by providing financial statements with budget comparison, so you can stay on top of variable costs, ensuring accurate financial control. Its automated reporting saves time and helps you make smarter, faster decisions, especially when integrated with effective business budgeting software.

Need to track costs across branches or projects? HashMicro’s multi-level analysis lets you compare variable costs effortlessly. With these features, you’ll streamline cost management and boost your bottom line. Get your free demo of HashMicro Accounting Software today and see the difference!

Conclusion

In conclusion, variable costing provides a clear picture of production costs by focusing on expenses that change with production. Using the variable costing formula, businesses can make informed decisions for short-term planning. Comparing absorption and variable cost, the latter offers more flexibility for internal management.

For accurate cost control, understanding the costing formula helps managers evaluate special orders without overestimating expenses. By analyzing variable cost examples, businesses can predict how increased production impacts profitability, avoiding mistakes in decision-making.

If these methods seem complex, try HashMicro’s Accounting Software. It provides accurate financial analysis and reduces manual tasks like bookkeeping and asset depreciation. HashMicro also offers other useful features. Subukan mo na! Get your free demo today!

Frequently Asked Questions about Variable Costing

• How to use variable costing?

  Variable cost is determined by adding direct labor cost, direct material cost, and variable manufacturing overhead, then dividing by the total units produced. The variable costing formula is: (Direct Labor Cost + Direct Raw Material Cost + Variable Manufacturing Overhead) ÷ Number of Units Produced.

• What is another name for variable costing?

  Variable costs, also known as prime or direct costs, fluctuate based on production levels. In contrast, fixed costs are time-based and remain steady over a specific period, while variable costs adjust according to changes in output volume.

• What is the role of variable costing in decision making?

  Variable costing helps in decision-making by setting targets for product sales or services. It allows us to calculate the company’s break-even point, which is essential for establishing sales goals.