Variable Costs

Variable costs are expenses that vary in proportion to the volume of goods or services that a business produces. In other words, they are costs that vary depending on the volume of activity. The costs increase as the volume of activities increases and decrease as the volume of activities decreases.

Direct materials
Direct labor
Transaction fees
Commissions
Utility costs
Billable labor
Essentially, if a cost varies depending on the volume of activity, it is a variable cost.

Total Variable Cost = Total Quantity of Output x Variable Cost Per Unit of Output

Variable costing is a concept used in managerial and cost accounting in which the fixed manufacturing overhead is excluded from the product-cost of production. The method contrasts with absorption costing, in which the fixed manufacturing overhead is allocated to products produced. In accounting frameworks such as GAAP and IFRS, variable costing cannot be used in financial reporting.

Although accounting frameworks such as GAAP and IFRS prohibit the use of variable costing in financial reporting, this costing method is commonly used by managers to:

Conduct break-even analysis to determine the number of units needed to be sold to begin earning a profit
Determine the contribution margin on a product, which helps to understand the relationship between cost, volume, and profit
Facilitate decision-making by excluding fixed manufacturing overhead costs, which can create problems due to how fixed costs are allocated to each product

Under variable costing, the following costs go into the product:

Direct material (DM)
Direct labor (DL)
Variable manufacturing overhead (VMOH)

Under absorption costing, the following costs go into the product:

Direct material (DM)
Direct labor (DL)
Variable manufacturing overhead (VMOH)
Fixed manufacturing overhead (FMOH)

In accordance with the accounting standards for external financial reporting, the cost of inventory must include all costs used to prepare the inventory for its intended use. It follows the underlying guidelines in accounting – the matching principle. Absorption costing better upholds the matching principle, which requires expenses to be reported in the same period as the revenue generated by the expenses.

Variable costing poorly upholds the matching principle, as related expenses are not recognized in the same period as related revenue. In our example above, under variable costing, we would expense all fixed manufacturing overhead in the period occurred.

The variable cost ratio is a cost accounting tool used to express a company’s variable production costs as a percentage of its net sales. The ratio is calculated by dividing the variable costs by the net revenues of the company. The company’s net revenue includes the sum of its returns, allowances, and discounts subtracted from the total sales.

The formula for the calculation of the variable cost ratio is as follows:
Variable Cost Ratio = Variable Costs / Net Sales

An alternate formula is given below:

Variable Cost Ratio = 1 – Contribution Margin
The contribution margin is a quantitative expression of the difference between the company’s total sales revenue and the total variable costs of production of goods that were sold. The contribution margin is expressed in percentage points.