Question

Using the Internet, review at least 3 articles on Variable Costing. Summary the articles in your own words.

As a manager, discuss how you would use Variable Costing in managerial decisions Support your response with numerical example(s)

Answer 1

VARIABLE COSTING

Variable costing is one of approach which is used for the purpose of valuation of inventory or calculation of the cost of the product in the company where only the cost linked directly with the production of output are applied to the inventory cost or the cost of the production and other expenses are charged as expense in the income statement.

Variable cost is linked to the production of output and it is the per unit amount which is incurred as a single unit is being produced. It increases as the number of units of production increase initially as per the economies of scale.

Examples of Variable cost

• Direct Raw Material
• Direct labour cost
• Commissions
• Utility Costs
• Freight Expenses
• Variable manufacturing overhead

Features of Variable Costing

Variable costing has the following features:

• In variable costing product cost is determined only based on variable manufacturing cost.
• Here, fixed factory overhead is regarded as a period cost and is charged against revenue in the period it is incurred,
• Variable costing operating income changes with sales not with production.
• Contribution Approach is followed in determining net income. Here, the variable cost of goods sold is subtracted from the sales to determine C/M and all fixed costs are subtracted from C/M to determine net income.
• There is no need to adjust under or over allocation of fixed factory overhead in variable costing as it is not included in the cost of production.

Advantages of Variable Costing

1. Operations planning : Variable costing can readily supply data on variable costs and contribution margin which management needs each day to take decisions relating to special order, expansion of capacity, shut-down of production, etc.

2. Product pricing : The variable cost of production is considered at the time of fixing the selling price for special order. Variable costing can readily supply data relating to the variable cost of production.

3. Management decisions : Variable costing income statements enables management to see and understand the effect that period costs have on profits and facilitates better decision-making.

4. Cost control : Cost control becomes easier because only variable manufacturing costs are considered.

5. Change in profit : Variable costing net income changes with sales. As a result, it becomes easily understandable as to how much additional profit will be earned from how much additional sales.

Disadvantages or Limitations of Variable Costing

1. Inaccurate cost: Directly identifiable fixed cost is specifically related to production. But all fixed costs are treated as a period cost, As a result, the cost of production may not be accurate.
2. Long-term pricing: Variable costing is not useful for long-term pricing policy simply because it does not consider fixed factory overhead as product cost.
3. Undervaluation of inventory: Under variable .costing, finished goods and work-in­progress are undervalued. This is because of the non-inclusion of fixed factory overhead in product cost. As a result balance sheet does not represent a true and fair view.
4. External reporting and tax reporting: Variable costing is not acceptable for external reporting and tax reporting until today. It is only applicable to internal management. It does not conform to GAAP.
5. Separation of costs into fixed and variable is a difficult task especially when such costs are semi-variable.
6. No cost is fixed in the long-run.

Managers may prefer variable costing because it classifies costs both by their function and their behavior. When costs are classified by behavior, managers can more accurately predict how total costs will change when volume changes.Using contribution margin format, company using variable costing system provides detail for cost volume profit (CVP) analysis. Using variable costing system we can also minimize our total cost, so we can say that variable costing is useful for controlling costs as it is foundation of managerial tools and planning.