Variable costing

Variable costing is a methodology that only assigns variable costs to inventory. This approach means that all overhead costs are charged to expense in the period incurred, while direct materials and variable overhead costs are assigned to inventory. There are no uses for variable costing in financial reporting, since the accounting frameworks (such as GAAP and IFRS) require that overhead also be allocated to inventory. Consequently, this methodology is only used for internal reporting purposes. However, it is quite commonly used in this role, where variable costs are used to:

  • Conduct breakeven analysis to determine the sales level at which a business earns a zero profit.
  • Establish the lowest possible cost at which a product can be sold.
  • Formulate internal financial statements into a contribution margin format (which must be adjusted before they can be issued to outside parties).

When variable costing is used, the gross margin reported from a revenue-generating transaction is higher than under an absorption costing system, since no overhead allocation is charged to the sale. Though this does mean that the reported gross margin is higher, it does not mean that net profits are higher - the overhead is charged to expense lower in the income statement instead. However, this is only the case when the level of production matches sales. If production exceeds sales, absorption costing will result in a higher level of profitability, since some of the allocated overhead will reside in the inventory asset, rather than being charged to expense in the period. The reverse situation occurs when sales exceed production.