Variable Costing

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Variable costing is a method of calculating product costs that includes only variable manufacturing costs in the cost of each unit, treating fixed production overheads as an expense of the period in which they occur.

Under variable costing, also called marginal or direct costing, a unit's cost includes direct materials, direct labour and variable overheads, but not fixed overheads. All fixed costs are charged against profit in full each period.

Using the same example as absorption costing, a factory makes 1,000 units with variable costs of 10 each and fixed overheads of 5,000, selling 800. Under variable costing, the 200 unsold units are valued at 10 each, or 2,000, and the full 5,000 of fixed overhead is expensed this period.

Variable costing makes the relationship between sales volume and profit clearer, because profit is not affected by changes in inventory levels. It supports contribution margin analysis, break-even analysis and short-term decisions, such as whether to accept a special order.

Variable costing is not allowed for external financial reporting under IFRS or US GAAP, which require absorption costing. Many companies therefore use variable costing for internal management reports and adjust to absorption costing for published accounts.

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