Variable costing

What it means

Variable costing assigns only variable costs to a product or service, meaning costs that change with output, such as materials, production energy or piece-rate wages. Fixed costs are treated as period costs and are not allocated to products.

The difference between the selling price and variable costs is the contribution margin towards fixed costs and profit. It shows how much each unit sold contributes to covering fixed costs and, once those are covered, to profit.

The opposite is absorption costing, which also allocates fixed overheads to products. Absorption costing is used mainly for inventory valuation, while variable costing is more useful for short-term management decisions.

How it works in practice

Variable costing makes decisions on pricing, product mix and orders easier. If a company has spare capacity, it can accept an order even at a price below full cost, provided the price covers variable costs and yields a positive contribution margin that helps cover fixed costs.

It is the basis for calculating the break-even point, the sales volume at which contribution margins exactly cover fixed costs. The company thus knows how much it must sell to avoid a loss and how the result changes with price or volume.

In management accounting, variable costing is often used to assess the profitability of products, customers and sales channels. In services such as accounting, variable costs are estimated mainly from the staff time needed per client.

What to watch out for

Deciding solely on contribution margin is appropriate in the short term. In the long run the company must also cover fixed costs, or it will make a loss. If every order were accepted at prices just above variable cost, the overall result could be negative.

For valuing own-produced inventory in the financial statements, the Accounting Act allows part of indirect production costs to be included in cost. Results from variable costing may therefore differ from the inventory value shown in the balance sheet.