Variable Costing

 

Variable Costing – Definition

Variable costing is a method of costing in which only variable production costs are included in product cost, while fixed manufacturing overhead is treated as a period expense.

Meaning of Variable Costing

In simple terms, variable costing focuses on costs that change directly with production volume. This method excludes fixed factory costs (like rent, salaries of permanent staff, and depreciation of equipment) from the product cost. Instead, these fixed costs are recorded as expenses in the period they are incurred.

Variable costing is also known as direct costing or marginal costing and is widely used for internal decision-making, profit planning, and cost control.

Key Components of Variable Costing

Under variable costing, the cost per unit includes only:

1. Direct Materials – Raw materials used in production.

2. Direct Labour – Wages paid to workers directly involved in manufacturing.

3. Variable Manufacturing Overhead – Costs that vary with production, such as utilities for running machines.

Fixed manufacturing overhead is excluded from the product cost and charged directly to the Profit & Loss account.

Example of Variable Costing

Suppose a company manufactures 1,000 units:

• Direct Material: ₹50 per unit

• Direct Labour: ₹20 per unit

• Variable Overhead: ₹10 per unit

• Fixed Overhead: ₹30,000 (per month)

Variable Cost per unit = ₹50 + ₹20 + ₹10 = ₹80

If 1,000 units are produced:
Total Variable Cost = ₹80 × 1,000 = ₹80,000

Fixed overhead of ₹30,000 will be charged as an expense in the current month.

Variable Costing in the Indian Financial System

In India, variable costing is not allowed for external financial reporting under the Companies Act or Ind AS; it must follow absorption costing.

However, it is widely used internally by businesses for:

• Cost-volume-profit (CVP) analysis

• Break-even analysis

• Decision-making for special orders and pricing strategies

• Budget control in manufacturing sectors

Why Variable Costing is Important

• Helps management in short-term decision-making

• Avoids misleading inventory valuation

• Useful in determining the break-even point

• Facilitates cost control by separating fixed and variable expenses

Formula for Variable Costing

Variable Cost per Unit = Direct Materials + Direct Labour + Variable Manufacturing Overhead

Total Variable Cost = Variable Cost per Unit × Units Produced

Journal Entry for Variable Costing

When incurring variable manufacturing costs:

Work-in-Progress A/c     Dr
   To Direct Materials A/c  
   To Direct Labour A/c  
   To Variable Overhead A/c

When selling goods:

Cost of Goods Sold A/c   Dr
   To Finished Goods A/c

Fixed overhead recorded as expense:

Fixed Overhead Expense A/c Dr
   To Cash/Payables A/c

Detailed Accounting Illustration

Scenario:
Production = 500 units
Direct Material = ₹40/unit
Direct Labour = ₹25/unit
Variable Overhead = ₹15/unit
Fixed Overhead = ₹20,000

Step 1: Calculate Variable Cost per Unit
= ₹40 + ₹25 + ₹15 = ₹80

Step 2: Total Variable Cost
= ₹80 × 500 = ₹40,000

Step 3: Selling Price
If Selling Price = ₹120/unit
Sales Revenue = ₹120 × 500 = ₹60,000

Step 4: Contribution Margin
= Sales Revenue – Total Variable Cost
= ₹60,000 – ₹40,000 = ₹20,000

Step 5: Net Profit
= Contribution Margin – Fixed Overhead
= ₹20,000 – ₹20,000 = ₹0 (Break-even point reached)

Legal Implications in India

• Not acceptable for statutory reporting under Indian Accounting Standards (Ind AS).

• Used only for internal reporting and decision-making.

• External reports must follow absorption costing as per Schedule III of the Companies Act, 2013.

Related Terms

• Absorption Costing
• Contribution Margin
• Break-even Analysis
• Marginal Costing
• Fixed Costs

FAQs

Q1. Is variable costing allowed in India for tax purposes?
No, for tax and statutory purposes, Indian companies must use absorption costing.

Q2. Why do managers prefer variable costing?
Because it shows the direct impact of production changes on profitability.

Q3. Can service companies use variable costing?
Yes, service-based businesses can apply the concept for internal cost analysis.

Expert Tip from Learn with Manika

"Always use variable costing for quick internal decision-making, but switch to absorption costing when preparing statutory financial statements in India. This way, you stay compliant while making smart business choices."