Introduction
Definition and Explanation
Variable costing is a perception primarily used in cost and managerial accounting whereby the fixed manufacturing overhead is excluded from the product cost of production and termed period expenses. Only the variable manufacturing costs are considered product costs. Akbar and Rezeki (2022) term variable costing as a method of evaluating the cost of production by only considering the cost of production that behaves mutable into the cost of production, and it comprises variable factory overhead, direct labor costs, and raw materials costs. This approach is discrete and categorizes the cost of information grounded on behavior about changes in the volume of production operations. The variable costing methodology calculates the cost of production and comprises elements of variable non-production costs plus the variable cost of production (Akbar & Rezeki, 2022). Variable costing determines the contribution margin on a product, conducting break-even analysis to examine the number of units required to be sold to start realizing a profit and facilitating decision-making by treating fixed manufacturing overhead costs as a period expense and excluding them.
Importance in Cost Accounting
Variable costing is relevant in cost accounting because it can present critical insights into decision-making processes, cost behavior, and enhancement of cost control within businesses. A study by Pong and Mitchel (2006) to evaluate the impact of choice between variable and full costing on the profitability of UK manufacturing firms revealed that reported profits vary depending on the method utilized. Although the study never mentioned the best method, organizations must select the best method to leverage it fully. Gersil and Kayal (2016) claim that variable costing is effective in relation to designating product prices, planning, managerial decision-making processes, analyzing the outcomes of business operations, and specifying break-even points due to its capability to differentiate between operating costs as either variable or fixed. The approach presents a margin analysis technique to management to evaluate the productivity of a product through a comparison of contribution margins and fixed costs, enabling organizations to highlight profitable segments or products and allocate resources appropriately. Additionally, variable costing presents a more accurate portrayal of income than other methods, such as absorption costing, which considers fixed factory overhead incurred even in low production, resulting in higher unit costs, probably misleading the financial statements and reports. It also acts as a tool for performance evaluation and control as management can examine the efficiency of operation by comparing budgeted amounts to actual variable costs: discrepancies signify areas for improvement, hence guiding the management in cost control strategies. Lastly, variable costing promotes accountability by directly associating costs with production activities, fostering a culture that encourages the workforce to take ownership of their action’s financial implications while promoting cost consciousness.
Strengths of Variable Costing
Improved Cost Control
- Focus on Variable Costs
One of the key strengths of variable costing is its capability to examine cost behavior by concentrating on variable costs. The approach distinguishes costs into fixed components and variable elements, allowing companies to better comprehend how cost fluctuations affect changes in production levels. A test conducted in a baking company revealed that variable costing is more reliable as it only involves costs related to the production costs in its calculations (Sinambela et al., 2022). Managers can understand how diverse variable costs, including direct labor, direct materials, and variable overheads, change proportionally with fluctuations in production volumes, allowing them to make sound decisions regarding production levels, resource allocation, production planning, and pricing strategies. For instance, if the production level decreases, the management can pinpoint opportunities to minimize virile costs to line up with lower production volumes. They can forecast the corresponding upsurge in variable costs and adjust pricing strategies when production levels increase. According to Ratnasih and Sulbahri (2022), variable costing splits up all components of production costs into fixed and variable costs and contribution limit calculations: this allows the management to be able to structure profits through cost-volume-earning relationship or break-even equations.
- Clear Identification of Cost Drivers
Variable costing presents a clear understanding of cost drivers, hence facilitating cost control within a firm. Managers can align variable costs connected to each product, hence being able to target areas for cost minimization, enabling the firm to reduce wastage, improve efficiency, and increase profitability. Eliminating waste in the production system, irrespective of its form (labor, material, or plant capacity), results in higher profitability (Katayama & Bennett, 1999). In this case, if direct labor is the cost driver of variable costs, the management can employ or invest in diverse techniques to streamline (invest in workforce training, improve employees’ productivity, or explore venues to streamline labor-intensive operations). The targeted approach of identifying the cost drivers enables firms to achieve sustainable cost reductions, optimize cost structures, improve their competitive advantage, and attain long-term financial success.
III. Better Decision Making
Contribution Margin Analysis
The contribution margin represents a cost-accounting tool for analyzing the measurement of the profitability of a product or the revenue after deducting fixed costs. Variable costing is calculated by subtracting all variable costs from total sales, and all fixed costs are then deducted in one block, resulting in operating income (Gutiérrez, 2021). Based on variable costing, every unit sold results in a specific amount towards generating a profit and covering fixed costs as a concept referred to as ad contribution margin per unit. Contribution margin analysis allows managers to make informed decisions concerning product offerings, pricing strategies, and production levels. For instance, a firm has diverse product lines. This analysis suits as it helps highlight the most profitable product line, and managers can concentrate on such by allocating resources appropriately and concentrating on production and promotion while optimizing low-margin offerings. The contribution margin also supports break-even analysis to examine the sales level necessitated to cover all costs at zero profit. This allows managers to make sound decisions regarding sales targets.
Flexibility in Pricing and Product Mix
Variable costing aids businesses’ decision-making process by offering flexibility in pricing and product mix decisions. Its nature of only concentrating on variable costs and excluding fixed costs allows firms to adjust prices and product offerings easily to maximize market share and profitability. For instance, it facilitates pricing decisions by pinpointing the incremental profit contribution of every extra unit sold; this aids the management in identifying key drivers of profitability, hence facilitating better pricing decisions. Ratnasih and Sulbahri (2022) state that variable costing presents frameworks for determining the selling price of a product through the utilization of cost-volume-earning, especially in the short term. The approach presents clarity regarding direct costs involved in the production of commodities, hence allowing the business to determine suitable pricing levels. The flexibility is achieved as managers can adjust the prices accordingly based on the variable costs; this ensures that every sale covers variable expenses positively and generates a contribution margin. Variable costing allows a firm to explore diverse product mixes to decide the most suitable based on profits or variable costs. This allows managers to focus on the most profitable by allocating resources to enhance overall profitability.
Weaknesses of Variable Costing
Incomplete Picture of Total Costs
- Exclusion of Fixed Costs
Although variable costing has diverse strengths, it also has several weaknesses. The approach works by excluding the fixed manufacturing overheads from the production cost, which presents a significant weakness as it presents an incomplete picture concerning total costs. Novak (2016) states that fixed factory overheads are never assigned to the product under variable costing, and only variable production costs are applied to a product. This means that the cost of production only considers direct labor, direct materials, and variable overheads, hence failing to capture the full cost of production despite presenting clarity concerning the direct costs associated with production and simplifying cost accounting. Irrespective of the level of production, fixed manufacturing overhead costs such as rent and depreciations are critical for the production process. For a more accurate representation of total costs, the fixed manufacturing overhead should ideally be assigned to products as they contribute to the overall cost structure of a business.
- Potential for Misinterpretation
The potential for misinterpretation is a serious concept in variable costing resulting from excluding fixed costs from production costs. These costs remain constant irrespective of production volume (rent), hence becoming critical in the production process. While comparing the full costing method theory and the variable costing theory, it emerged to have higher yields as it considers both fixed and variable costs in its production costs (Akbar & Rezeki, 2022). In this case, the cost of production is lower in variable costing and higher in full costing as the variable costs exclude a critical element (fixed factory overheads) in production. This scenario may result in misinterpretations as some managers may term it the best method without considering what it excludes in its production costs. The higher profits or low cost of production while using variable costing may not precisely reflect the accurate picture of the profits. This may mislead the management to the extent of allocating resources grounded on misleading profit metrics. It may also mislead stakeholders in the decision-making process.
Periodic Fluctuations in Profit
- Impact of Volume Changes
Attributed changes in production volume in variable costing result in periodic profit fluctuations due to its nature of not assigning fixed costs to products. In this approach, fixed costs remain constants and are excluded from the total cost of production; hence, whenever the production volume increases or decreases, the fixed costs remain constant, resulting in an unpredictable influence on profitability. Gersil and Kayal (2016) state that in variable costing, fixed factory overhead is incurred irrespective of production; the proponents rule them out from product cost: they are excluded from the inventoriable costs. In this case, there are higher profits in case of a rise in production volumes resulting from increased revenue generated from increased sales: irrespective of this, the extra revenue may not fully cover the fixed costs incurred since the fixed factory overhead is not allotted to products. On the other hand, low profits or losses may result due to declined production volume since fixed costs remain constant even when revenue decreases. These periodic fluctuations in profits have substantial implications for decision-making within a business as managers may find it hard to appropriately evaluate the organizational financial performance and make informed decisions concerning pricing strategies, resource allocation, and investment opportunities.
- Lack of Stability in Reporting
Variable costing could result in an overstatement of profit numbers resulting from its nature of considering only fixed variable costs (Gersil & Kayal, 2016). This may complicate performance evaluation and comparison with competitors, and stakeholders may find it hard to tell whether the presented figures reflect the business performance. Additionally, the fluctuations make it challenging for stakeholders to determine whether the fluctuating profits are the proceedings of the business improvements, inherent flaws in the costing methodology, or changes in the industry. This hinders decision-making, undermines stakeholders’ confidence in financial statements, and complicates performance evaluation. For instance, creditors may hesitate to issue loans to the business if they find its financial performance volatile or unpredictable. Similarly, investors may find evaluating the business’s long-term growth potential or profitability challenging, resulting in uncertainties and probably affecting stock prices.
Application of Variable Costing in Different Businesses
Manufacturing Industry
- Strengths in High-Volume Production
In a world characterized by many large industrial companies, variable costing has been utilized fully to provide exceptional critical tools for planning and controlling operations (Hasan, 2015). Although it is not utilized broadly compared to absorption costing, it is increasingly gaining popularity, especially in manufacturing, due to its notable strengths (high-volume production). In the manufacturing sector, where production levels are constantly high, variable costs institute a substantial portion of total costs, which vary directly proportionate to changes. The strength behind high production volume is the capacity to present a clear and straightforward comprehension of the cost structure by concentrating only on variable costs as the production cost; variable costing simplifies cost analysis and enhances cost control efforts. Most companies are product-focused and are conscious of strategic direction while focusing on variable costs (Katayama & Bennett, 1999). Focusing on variable costs allows managers to easily track the direct association between variable costs and production volume, allowing businesses to concentrate on optimizing their production process, improving overall operational efficiency, and identifying cost-saving opportunities. It also facilitates decision-making in high-volume production by presenting the management with timely cost information, hence making informed decisions regarding pricing strategies, production levels, and resource allocation. In general, variable costing strength in high-volume production is influenced by its capacity to present clarity, promote flexibility, and facilitate decision-making.
- Weaknesses in Overhead Allocation
Due to variable costing not being attributed to production costs, the approach presents challenges, especially in overhead allocation. Treating fixed factory overhead as period expenses rather than assigning them to products based on production levels presents a significant weakness. Although they do not change the production volume, they are necessary for production. Agility-focused businesses tend to have moved toward cost adaptability, which aims to lower the break-even point and reduce fixed costs rather than focus solely on variable costs (Katayama & Bennett, 1999). Focusing solely on variable costs can distort product profitability calculation, hence the wrong decision within a business. This can also affect strategic planning and resource allocation, potentially hindering the business’s capability to maximize its competitiveness and profitability. Challenges in overhead allocation complicate performance evaluation and comparison within the sector competitors due to inaccurate financial performance reports that result in uncertainty in credit ratings and investment decisions.
Conclusion
Variable costing forms a critical aspect of product costing as a section of the internal reporting framework for organizations. It presents diverse advantages, including enhancing informed decision-making and cost control through margin analysis. Nevertheless, it is relevant to acknowledge its weaknesses, such as periodic profit fluctuations and incomplete depiction of total costs. Although variable costing is effective in manufacturing, especially in high-production organizations, it also faces overhead allocation challenges. Organizations must thoroughly evaluate such aspects while considering other costing methods to comprehend financial performance comprehensively.
References
Akbar, J. S., & Rezeki, N. S. (2022). THE INFLUENCE OF COST OF PRODUCTION FULL COSTING AND VARIABLE COSTING METHODS ON SALES RESULTS (CASE STUDY IN KRIPIK CUMI COMPANY IN BANGKA DISTRICT). International Journal of Economics, Business and Accounting Research (IJEBAR), 6(4).
Gutiérrez, M. (2021). Making better decisions by applying mathematical optimization to cost accounting: An advanced multi-level contribution margin accounting approach. Heliyon, 7(2).
Hasan, M. (2015). Variable costing and its applications in manufacturing companies. International Scholar Journal of Accounting and Finance, 5(1).
Katayama, H., & Bennett, D. (1999). Agility, adaptability, and leanness: A comparison of concepts and a study of practice. International journal of production economics, 60, 43-51.
Novak, P. (2016). Comparison of managerial implications for utilization of variable costing and throughput accounting methods. Journal of Applied Engineering Science, 14(3).
Pong, C., & Mitchell, F. (2006). Full costing versus variable costing: Does the choice still matter? An empirical exploration of UK manufacturing companies 1988–2002. The British Accounting Review, 38(2), 131–148.
Ratnasih, C., & Sulbahri, R. A. (2022). Full costing method model and variable costing method against cement price determination (Case in Indonesia). European Journal of Business and Management Research, 7(2), 284-288.
Sinambela, E. A., Darmawan, D., & Gardi, B. (2022). Production Cost Calculation Analysis Using Variable Costing Method. International Journal of Service Science, Management, Engineering, and Technology, 1(2), 13-16.
Gersil, A., & Kayal, C. (2016). A comparative analysis of normal costing method with full and variable costing in internal reporting. International Journal of Management (IJM), 7(3), 79-92.
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