Variable Costing Income Statements separate costs from expenses

In accounting terms, companies use different costing techniques to calculate the cost of a given product. The use of the techniques depends on various factors, but with one objective, establishing the company’s expenses to produce an effect.

Generally, several costing methods are used for the best results. What changes is the technique, and at this point, a specific one is applied in financial accounting.

A Variable Cost Income Statement separates costs from expenses. To make an income statement is necessary to use the calculation methods since they are crucial to determining how much a company spends on a given product.

What is a Variable Cost Income Statement?

Every company seeks profits, and to obtain them; it needs to know how much it spends. This data is received in a Variable Cost Income Statement, a report made under the variable cost method. In it, the company deducts variable expenses for a period.

Profits are known as the contribution margin on a specific product. When achieving such contribution, the variable cost-profit and loss calculation deducts fixed costs, considering those costs as expenses of the chosen period.

The Variable Cost Profit and Loss Statement report reflect the subtraction of variable expenses from revenues. In this way, the contribution margin is obtained, from which the fixed costs are subtracted to arrive at the net profit or loss for the period.

For companies, it is useful to determine the expenses that vary directly with revenues. Those with a high percentage of fixed production expenses and low administrative and variable selling expenses will be higher than the gross margin.

To get an idea of how some costing methods are applied to achieve the Variable Cost Income Statement, this formula for net profit and loss is used:

  • Contribution Margin = Revenue – Variable Production Expenses – Variable Commercial and Administrative Expenses.
  • Net profit or loss = Contribution margin – Fixed production expenses – Fixed selling and administrative expenses.

For the execution of the formula, consider that, in some cases, direct production labor is classified as a fixed expense within the Income Statement format and not as a variable expense.

The cost of direct labor does not change direction to the amount of revenue generated. On the contrary, the company needs to maintain a certain number of production area employees within a range established by the production volume.

Generating a Variable Cost Income Statement is useful to determine the volume of expenses that varies directly with revenues.

Variable cost vs. absorption cost

Companies use two methods to know the value of work in process and product inventoryvariable cost and absorption cost. To understand how to run a Variable Cost Income Statement report is important to differentiate between them.

Variable cost is the method where all variable expenses are allocated to a product, and fixed overhead expenses are counted in the period incurred. The latter costs are not included in the total value of the inventory.

On the other hand, absorption costing is the method where all direct costs, fixed indirect costs, and variable indirect manufacturing costs are applied to the cost of the product. The inventory value includes direct material and all overhead costs.

The absorption cost allocates fixed costs to a product according to activity level. It absorbs these costs into the cost of the product. On the other hand, variable costing ignores fixed costs when calculating the cost of products and uses them as a period cost.

According to accounting rules, a company cannot produce an Income Statement using the variable cost method. They must stick to absorption costing techniques to comply with the laws.

However, they can perform the variable cost method internally for management accounting. This includes the Variable Cost Income Statement.

How is a Variable Cost Income Statement prepared?

Understanding the difference between variable cost and absorption cost, preparing an Income Statement is very easy, especially since it has some similarities to the traditional format.

  1. Start with revenue. Then reduce variable costs by that amount. That is, direct labor and material expenses, as well as any other variable expenses that are associated with operations.
  2. The Income Statement already obtains the contribution margin bsubtracting costs from revenues. It has a certain resemblance to the gross profit of the traditional format. It differs in that the contribution shows the most relevant profits when manufacturing a specific product. Fixed costs are not absorbed in this calculation.
  3. It now includes fixed costs as costs for a period. When obtaining the result, it calculates the contribution margin and subtracts the fixed costs (salaries, sales, distribution, and rent, among others).
  4. The Variable Cost Income Statement reflects the net income by subtracting the fixed costs from the contribution margin. The figure is usually similar to a traditional income statement.

It should be noted that, although the Variable Cost Income Statement shows net income, net income is not usually its primary objective; rather, it emphasizes contribution margins.

What differentiates contribution margin and gross margin is that fixed production costs are within the cost of goods sold to achieve gross margin. For contribution margin, fixed production costs are not included in the same calculation.

This means that the Variable Cost Income Statement is made based on the changing underlying cost information and not on the functional areas included in the traditional income statement.

Advantages of a Variable Cost Income Statement Report

For a company, the Variable Cost Income Statement is vital in decision making, as it allows it to determine the profitability of a specific product. The downside is that it does not show the true profitability of a product when fixed costs are not included.

Beyond that, there are advantages that a company’s management should take advantage of. For example, variable cost provides a better understanding of the effect of fixed costs on net profit on the Variable Cost Income Statement.

Companies with cash flow difficulties can take advantage of the net operating income because it is close to cash flow.

A Variable Cost Income Statement provides the revenue needed for the cost-volume-profit analysis. Data that cannot be extracted from the traditional income statement.