A variable cost is an expense that rises and falls in proportion with how much your business produces or sells. A variable costing income statement is a type of income statement in which you subtract variable expenses from total sales revenue to arrive at a separate line item called contributions margin. Contributions margin is the money left over from sales after paying all variable production expenses. From there, you subtract fixed expenses, such as rent and salaries, to get your net income, or profit.
Read on for a closer look at variable costing income statements, including how they differ from traditional income statements, what they can tell you about your small business, and the pros and cons of preparing this type of income statement.
Key Points
• Variable costing income statements are financial reports that distinguish variable costs from fixed costs.
• Variable costs fluctuate and may include the cost of materials, labor, manufacturing, sales commissions, shipping, packaging, and transaction fees.
• Total sales minus variable costs gives you your contribution margin, which is the amount of money left over to cover fixed costs and generate profit.
What Is Variable Costing?
Your business incurs both variable and fixed costs. Variable costs fluctuate depending on the number of products you produce or sell, whereas fixed costs stay the same regardless of how much you produce or sell.
Variable costing is a method of cost accounting that excludes fixed manufacturing expenses from the cost of making products. It differs from absorption costing, in which you allocate fixed overhead costs to products produced.
Variable production costs include the cost of materials, packaging, and supplies. In some cases, variable costs might also include overhead costs that vary based on the number of products sold, such as commissions paid to salespeople. To calculate your total variable production expenses, you add your total variable cost of goods sold with your total variable selling expenses.
While the Generally Accepted Accounting Principles (GAAP) does not allow the use of variable costing in financial reporting, business owners and managers will often use the variable costing method to calculate the contribution margin, which is the metric that tells you your break-even point, or how many units need to be sold before you start earning a profit.
Recommended: Break-Even Analysis: How to Calculate and Examples
What Are Variable Costing Income Statements?
A variable costing income statement is a financial report in which you subtract variable expenses from revenue, resulting in a contribution margin. From there, you subtract all fixed expenses to arrive at the net profit (or loss) for the accounting period.
Variable costing income statements differ from traditional income statements in that all fixed production costs are listed lower in the statement, after the contribution margin. Fixed overhead is regarded as a period cost and is charged against revenue in the period it is incurred.
Two other key differences:
• All variable selling and administrative expenses are combined with variable production costs to calculate contribution margin.
• Gross margin (which includes both variable and fixed production costs in the cost of goods sold) is replaced by the contribution margin (which only includes variable costs in the cost of goods sold).
Under both a variable costing income statement and a normal income statement, the net profit or loss will be the same.
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Examples of Variable Costing Income Statements
Here are two examples of how variable costing statements are used across different industries:
Example 1: Manufacturing Company
XYZ Manufacturing produces custom furniture. In a given month, the company sells 500 units at $200 each, resulting in $100,000 in sales. The variable costs include:
• Direct materials: $50 per unit
• Direct labor: $30 per unit
• Variable manufacturing overhead: $10 per unit
Total variable costs per unit are $90. The total variable cost for 500 units is $45,000. The contribution margin is calculated as:
Contribution Margin = Sales − Variable Costs = $100,000 − $45,000 = $55,000
Fixed costs for the period, including rent, salaries, and fixed overhead, are $30,000. The net operating income under variable costing is:
Net Operating Income = Contribution Margin − Fixed Costs = $55,000 − $30,000 = $25,000
Example 2: Service Company
ABC Consulting provides marketing services. In a month, the company earns $80,000 in revenue. Variable costs include:
• Consultant fees: $20,000
• Marketing materials: $5,000
Total variable costs are $25,000. The contribution margin is:
Contribution Margin = Revenue − Variable Costs = $80,000 − $25,000 = $55,000
Fixed costs, such as office rent and administrative salaries, total $20,000. The net operating income is:
Net Operating Income = Contribution Margin − Fixed Costs = $55,000 − $20,000 = $35,000
These examples illustrate how variable costing income statements provide a detailed view of profitability by separating variable and fixed costs.
How to Create a Variable Costing Income Statement
Creating a variable costing income statement involves several key steps to distinguish between variable and fixed costs. Here’s a step-by-step guide:
1. Gather Financial Data
Start by collecting all relevant financial data for the period, including sales revenue, variable costs, and fixed costs. Ensure you have detailed records of all costs associated with production and operations.
2. Identify & Calculate Variable Costs
Variable costs are expenses that fluctuate with production levels. Common variable costs include:
• Direct Materials: Costs of raw materials used in production.
• Direct Labor: Wages paid to workers directly involved in manufacturing.
• Variable Manufacturing Overhead: Costs that vary with production volume, such as utilities for manufacturing facilities.
• Sales Commissions: Payments to sales staff based on sales performance.
Sum all variable costs for the period. This will give you the total variable costs, which will be subtracted from sales revenue to determine the contribution margin.
3. Compute the Contribution Margin
The contribution margin is the difference between sales revenue and total variable costs. It indicates how much revenue is available to cover fixed costs and contribute to profit.
Contribution Margin = Sales Revenue − Total Variable Costs
4. Identify Fixed Costs
Fixed costs are expenses that remain constant regardless of production levels. These typically include:
• Rent: Costs for business premises.
• Salaries: Fixed wages for administrative and management staff.
• Depreciation: Allocation of the cost of tangible assets over their useful lives.
• Fixed Manufacturing Overhead: Costs such as insurance and property taxes.
5. Calculate Net Operating Income
Subtract total fixed costs from the contribution margin to determine net operating income:
Net Operating Income = Contribution Margin − Total Fixed Costs
6. Format the Income Statement
Present the data in a clear, structured format. A typical variable costing income statement includes:
• Sales Revenue
• Less: Variable Costs
◦ Direct Materials
◦ Direct Labor
◦ Variable Manufacturing Overhead
◦ Sales Commissions
• Contribution Margin
• Less: Fixed Costs
◦ Rent
◦ Salaries
◦ Depreciation
◦ Fixed Manufacturing Overhead
• Net Operating Income
Pros and Cons of Variable Costing Income Statements
| Pros | Cons |
|---|---|
| Provides all the data needed to conduct a break-even analysis | By ignoring overhead costs, variable costing may understate a product’s overall cost |
| Offers a more accurate picture of your cash flow | Can sometimes be difficult to determine if a cost is fixed or variable |
| Gives you a clearer picture of the effect of fixed costs on net profit | Not GAAP compliant |
| Helps you more accurately set the price of a special order | Might need to have two sets of income statements (normal for external use, and variable for internal use) |
Normal Income Statements vs Variable Costing Income Statements
| Normal Income Statement | Variable Costing Income Statement | |
|---|---|---|
| Accounting method | Absorption costing | Variable costing |
| How overhead costs are treated | Per-unit basis | Periodic basis |
| Type of margin calculated | Gross margin | Contribution margin |
| GAAP compliant? | Yes | No |
Both variable costing income statements and normal income statements report a company’s profit or loss for a specific accounting period. However, they arrive at a company’s “bottom line” in different ways.
Traditional income statements use absorption costing, which allocates all manufacturing costs to finished goods. Fixed overhead costs are spread out among all goods produced and added to the total cost of producing each good.
By contrast, variable costing income statements use variable costing. With this approach, only variable costs are included in the cost of goods sold; overhead costs are considered on a periodic basis rather than a per-unit basis and listed lower in the statement.
Another key difference is that a standard income statement calculates a gross margin, while a variable costing income statement calculates a contribution margin.
Recommended: How to Read Financial Statements
Other Kinds of Income Statements
All income statements report a company’s profit or loss. However, they can be formatted in different ways. Here’s a look at two other types of income statements.
Contribution Margin
Just like the variable costing income statement, a contribution margin income statement only includes variable expenses in the cost of goods sold, and pushes fixed production costs lower down in the statement to make it easier to understand the contribution margin on sales.
Traditional
A traditional income statement focuses on the revenue, expenses, gains, and losses of a company during a particular period. This format is GAAP compliant and uses absorption costing, which captures all costs (fixed and variable) associated with manufacturing a particular product.
Recommended: How to Read a Profit & Loss Statement
The Takeaway
A variable costing income statement is a financial report prepared using the variable costing method, in which you only deduct variable expenses from total sales for a specific period to come up with a contribution margin. The statement then deducts fixed costs, which it considers period costs.
Variable costing income statements are typically prepared for internal use to help inform decisions about pricing and cost management. However, this type of income statement is not GAAP compliant. If you decide to seek outside funding through an investor or a small business loan, you will likely need to prepare a traditional income statement.
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FAQ
What are the advantages of using variable costing when preparing income statements?
Advantages of financial statements prepared under variable costing include helping you conduct a break-even analysis, or how much your company must sell at a certain price before it shows a manufacturing profit. It also provides a more accurate picture of your cash flow, which can be particularly important for small businesses with tight margins.
What exactly is variable costing? What are variable costs?
Variable costing is an accounting method for calculating production expenses where only variable costs are included in the product cost. Variable costs are those that rise and fall in proportion with the amount of goods a company produces or sells. They include direct labor costs, direct raw material costs, and variable manufacturing overhead.
Which costs are treated as product costs under variable costing?
Under variable costing, only those production costs that vary directly with output are treated as product costs. These include direct labor costs, direct raw material costs, and variable manufacturing overhead.
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