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.
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 metric that tells you your break-even point, or how many units need to be sold before you start earning a profit.
Recommended: Credit Memo vs Debit Memo
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.
Recommended: Commercial Equity Line of Credit
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 statements 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 cost 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 cost 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.
If you’re seeking financing for your business, SoFi can help. On SoFi’s marketplace, you can shop top providers today to access the capital you need. Find a personalized business financing option today in minutes.
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 much your company must sell at a certain price before it shows a manufacturing profit. And it 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.
Photo credit: iStock/staticnak1983
SoFi's marketplace is owned and operated by SoFi Lending Corp. See SoFi Lending Corp. licensing information below. Advertising Disclosures: SoFi receives compensation in the event you obtain a loan through SoFi’s marketplace. This affects whether a product or service is featured on this site and could affect the order of presentation. SoFi does not include all products and services in the market. All rates, terms, and conditions vary by provider.
Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.
SOSB0324020