Definition: Variable costing, also called direct costing, is an accounting method used to allocate production costs to product being produced. This method allocates all variable-manufacturing costs to the product during the period.
What Does Variable Costing Mean?
What is the definition of variable costing? Businesses follow two basic costing approaches: variable costing, also known as marginal costing, which is mainly used for internal reporting, and full costing, also known as absorption costing, which is used primarily for reports of a company to the external environment.
Direct costing treats the fixed manufacturing overhead costs as expensed during the period in which they are incurred. These costs follow the product until it is sold, and they are expensed on the income statement as costs of goods sold. On the contrary, absorption costing allows income to grow as production rises.
What is the difference between variable and absorption costing? Let’s look at an example.
Example
Mark works as an accountant at a leading manufacturing company that produces equipment for pediatric private practice. He is asked to calculate the operating income using the direct costing and the absorption costing methods and compare them. Under the direct costing method, Mark calculates the variable cost of goods sold at 50% of sales to find the product margin, and he deducts the variable expenses to find the contribution margin.
Hence, the fixed manufacturing overheads are allocated against sales during the period in which they are incurred. Also, variable costs comprise of direct materials, direct labor, and variable manufacturing overheads. After deducting the fixed costs from the contribution margin, Mark finds that the company’s operating income is $100,000.
Under the absorption costing method, Mark calculates the cost of goods sold at 70% of sales to find the gross margin, and he deducts the operating expenses (which are the sum of variable expenses and fixed expenses under the indirect costing method), to find that the company’s operating income is $100,000.
Hence, with both methods, he arrives at the same conclusion, but the difference is in the way each method allocates the fixed manufacturing overheads on the income statement.
Summary Definition
Define Variable Costing: Variable costing means a method of accounting for production expenses where all variable costs are included in the product cost during the period.
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