6.2 Variable Costing

Variable costing (also known as direct costing) treats all fixed manufacturing costs as period costs to be charged to expense in the period received. Under variable costing, companies treat only variable manufacturing costs as product costs. The logic behind this expensing of fixed manufacturing costs is that the company would incur such costs whether a plant was in production or idle. Therefore, these fixed costs do not specifically relate to the manufacture of products.  The following video explains the concepts in variable costing:

Product costs, under variable costing, includes the VARIABLE costs only like direct materials, direct labor and variable overhead.  Fixed overhead would not be included as a product cost!  We calculate product cost per unit as:

Direct Materials
+ Direct Labor
+ Variable Overhead
= Total Product Cost
÷ Total Units Produced
= Product cost per unit

The income statement we will use in not Generally Accepted Accounting Principles so is not typically included in published financial statements outside the company.  This contribution margin income statement would be used for internal purposes only.  You should remember, the contribution margin income statement separates variable costs and fixed costs (whether product or period does not matter) and calculates a contribution margin (this is sales – variable costs).  Now, let’s continue with our example Bradley Company.

Bradley Company had the following information for May:

  • Direct materials $13,000
  • Direct labor $15,000
  • Variable overhead $5,000
  • Fixed overhead $6,000
  • Fixed selling expenses $15,000
  • Variable selling expenses $0.20 per unit
  • Administrative expenses $12,000
  • 10,000 units produced
  • 9,000 units sold (1,000 remain in ending finished goods inventory)
  • Sales price $8 per unit

First, we will calculate the variable cost product cost per unit:

Direct Materials $ 13,000
+ Direct Labor $ 15,000
+ Variable Overhead $ 5,000
= Total Product Cost $ 33,000
÷ Total Units Produced ÷ 10,000
= Product cost per unit $ 3.30

Next, we calculate the contribution margin format income statement under variable costing:

Bradley Company
Income Statement (variable)
For Month Ended May
Sales (9,000 x $8 per unit) $ 72,000
Variable Costs:
    Cost of goods sold (9,000 x $3.30 per unit)  29,700
    Selling expenses (9,000 x $0.20 per unit)  1,800
    Total variable costs    31,500
Contribution Margin    40,500
Fixed Costs:
    Fixed overhead  (fixed portion only)   6,000
    Selling expenses (fixed portion only)     15,000
    Administrative expenses  12,000
    Total Fixed expenses     33,000
Net Operating Income     $ 7,500

In variable costing, it is important to remember:

  • ONLY includes variable costs meaning costs that increase with volume
  • Does not include FIXED costs as volume levels do not change these costs (fixed costs treated as period costs not product costs)
  • Can provide more accurate information for decision makers as costs are better tied to production levels
  • Can be applied to ALL costs and not just product costs.
  • Uses Contribution Margin Income Statement showing Sales – VARIABLE expenses = Contribution Margin – Fixed Expenses = Net Income and is based on the number of units SOLD.