Companies use various costing techniques to determine the cost of a specific product. This process is crucial in establishing the expenses borne by a company to produce that product. Consequently, companies can use the information to set the price for that product. It is crucial in determining the profits the company expects to make and how it can achieve those targets.
Each costing technique has its merits and demerits. Using these techniques falls under the managerial accounting process within a company. Usually, companies can utilize several costing methods for the best results. However, they can only use specific techniques during financial accounting. Nonetheless, these costing methods are crucial in helping determine the costs of a product.
Companies can also combine aspects of managerial and financial accounting. In costing techniques, they can prepare the income statement for each method. This way, they can understand how different decisions can impact that statement. One such income statement falls under variable costing. Before discussing the variable costing income statement, it is crucial to understand the technique first.
What is Variable Costing?
Variable costing allows companies to calculate production expenses based on variable costs only. It involves determining the product cost for a specific product without considering fixed costs. Usually, variable costing includes direct expenses involved in the production process. These consist of direct labour and direct labour. On top of that, it also requires variable manufacturing overheads as a part of the calculation.
Variable costing allows companies to understand how their activity levels impact their costs. Since variable costs only relate to how much a company operates, this costing method is highly critical. Variable costing can also be a significant part of the decision-making process. More specifically, it is vital in determining the relevant costs for a specific job, project or process.
Variable costing impacts the costs associated with producing specific products. Similarly, it assigns only variable costs to inventory. Consequently, it allows companies to charge all overhead costs to expenses in a specific period. This way, fixed costs become the period costs for that interval. On the other hand, direct costs, such as labour and material, become a part of the product cost.
Variable costing also differs from absorption cost. In the latter, companies allocate specific fixed costs to a product based on an activity level. This way, they absorb those costs into the product cost. However, variable costing ignores fixed costs when calculating those product costs. Instead, it uses them as a period cost. It implies that those costs are not a part of the product cost. Nonetheless, they are crucial in determining profitability for a period.
Accounting standards do not allow companies to prepare their income statements under the variable costing method. Companies must stick to the absorption costing technique to conform to financial accounting regulations. Nonetheless, companies can use variable costing internally within managerial accounting. Consequently, they can also prepare the variable costing income statement.
What is a Variable Costing Income Statement?
A variable costing income statement is a report prepared under the variable costing method. In this statement, companies only deduct variable expenses for a specific period. Similarly, those profits are known as the contribution to a particular product. Once it arrives at that contribution, the variable costing income statement deducts fixed costs. As stated above, it considers those costs as period costs.
The variable costing income statement considers both variable and fixed costs. However, it emphasizes more on the former. Similarly, it uses a different format than a traditional income statement. The variable costing income statement does not calculate profits. Instead, it focuses on the contribution margin. This margin is similar to profits. However, it does not include an adjustment for fixed cost absorption.
The contribution margin within the variable costing income statement is substantially higher than gross profits. It occurs because the fixed costs absorbed in the latter are not a part of the former costing method. Consequently, it results in lower product costs, which leads to higher contributions. For most companies, fixed costs represent a significant portion of total costs. Therefore, it causes a significant difference between gross and contribution margins.
The variable costing income statement can be significantly crucial in decision-making. It allows companies to determine the profitability of a specific product or multiple ones. However, the variable costing income statement can have its demerits. It does not allow companies to understand the actual profits associated with a product when not involving fixed costs.
Overall, the variable costing income statement is a report that companies prepare under managerial accounting. It only considers the variable costs when determining product costs. Consequently, it allows companies to calculate the contribution margins for a specific product. On the other hand, it treats fixed costs as a period cost. Therefore, it still considers those costs when calculating profits.
How to prepare the Variable Costing Income Statement?
Preparing the variable costing income statement is straightforward. Like the traditional format, it starts with revenues. From there, it deducts variable costs from that amount. These costs consist of direct material and labour expenses. On top of that, it also considers any other variable costs associated with operations. These may include overheads, production overheads, sales overheads, variable selling and admin costs, etc.
After deducting those costs from revenues, the variable costing income statement reaches the contribution margin. It is similar to gross profits in a traditional income statement. However, it is also very different. Essentially, contribution shows the relevant profits of manufacturing a specific product. It does not absorb the fixed costs into the calculation.
As stated above, the variable income statement considers fixed costs as a period cost. Therefore, the next step within the process is including those costs. Once this income statement calculates the contribution margin, it subtracts the fixed costs. These costs may include various items, such as rent, salaries, fixed manufacturing, selling and distribution overheads, etc.
After deducting the fixed costs from the contribution margin, the variable costing income statement reaches the net income. This income is similar to that reported under a traditional income statement. However, the method to arrive at this income is different under both approaches. However, the net income is not the focus of the variable costing income statement. Instead, it emphasizes contribution margins.
What is the format of the Variable Costing Income Statement?
The variable costing income statement uses a specific format. While this format may differ from one company to another, the process and primary elements are the same. An example of the variable costing income statement is as below.
|– Direct material|
|– Direct labour|
|– Variable overheads|
|– Other variable expenses|
|3||Contribution margin (1 – 2)||XXXX|
|5||Net Income/(loss) (3 – 4)||XXXX/(XXXX)|
What is the difference between the Traditional and Variable Costing Income Statement?
There are many differences between conventional and variable costing income statements. The primary one is that the latter considers the contribution margin. On the other hand, the traditional format calculates the gross profits. On top of that, it also reports operating and net income before taxes. However, the variable income statement only considers the contribution margin.
The variable costing income statement also categorizes costs by their nature. Consequently, it separates those costs based on whether they vary or remain fixed. On the other hand, the traditional income statement classifies costs based on their function. Therefore, it segregates those costs depending on the areas where they occur.
The traditional income statement also considers fixed costs under absorption costing. Therefore, it includes those costs as a part of the product cost. However, the variable costing income statement considers fixed costs a period cost. It deducts those costs from the contribution margin. These features are also why the variable costing income statement is not allowed under financial reporting.
Variable costing includes determining a product’s cost based on expenses that vary with activity levels. Companies can also prepare an income statement under this method. However, it does not use the same format as a traditional one. The variable costing income statement is highly crucial in managerial accounting. However, it emphasizes the contribution margin for a product.