What is 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. A business may use variable costing in order to more easily derive its contribution margin, which is net sales minus all variable costs. The contribution margin is a key input into the breakeven calculation, which is used to derive the sales level at which a business generates a zero profit. This, in turn, is useful for calculating the number of units that must be sold in order to break even, and so drives the pricing and product positioning strategy of a business.

When to Use Variable Costing

Here are several scenarios in which it can make sense to use variable costing:

Internal decision-making. Variable costing is useful for internal management decisions, such as pricing strategies and cost control. Since it separates fixed costs from variable costs, managers can analyze the true incremental cost of producing additional units. This helps businesses set competitive prices and optimize production levels without misleading fixed cost allocations.
Break-even and profitability analysis. Businesses use variable costing to conduct break-even analysis and assess profitability more accurately. By excluding fixed overhead from inventory, companies can determine the exact contribution margin per unit. This allows management to identify the sales volume required to cover fixed costs and achieve profitability.
Performance evaluation. When evaluating department or product-line performance, variable costing provides a clearer picture of controllable costs. Managers can assess how efficiently variable costs are managed without the influence of fixed costs, which are typically beyond their control. This improves accountability and encourages cost-saving measures where they matter most.
When facing fluctuating production levels. Businesses with highly variable production levels benefit from variable costing as it prevents distortions in profit reporting. Under absorption costing, fixed overhead costs are spread across varying inventory levels, leading to fluctuations in reported profits even when sales remain stable. Variable costing ensures that profits reflect actual sales performance rather than changes in inventory levels.

Why Variable Costing is Not Used in External Reporting

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. The frameworks do not favor the use of variable costing, because it does a poor job of matching revenues with all related expenses. Under variable costing, overhead costs are charged to expense at once, rather than when the related sales occur (which may be in a later period). Consequently, this methodology is only used for internal reporting purposes.

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How to Use Variable Costing

Variable costing is quite commonly used by management to assist with a variety of decisions. For example, one might conduct a breakeven analysis to determine the sales level at which a business earns a zero profit. Another possibility is to use it to establish the lowest possible price at which a product can be sold. Yet another use is to formulate internal financial statements into a contribution margin format (which must be adjusted before they can be issued to outside parties).

Variable Costing vs. Absorption Costing

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.