Variable Costing

3.1 The Variable Costing Income Statement

• A variable costing income statement is one in which all variable expenses are
deducted from revenue to arrive at a separately-stated contribution margin, from
which all fixed expenses are then subtracted to arrive at the net profit or loss for the
period.
• A variable costing income statement helps you determine the price to charge for
products to cover all costs and make a profit. Expenses may vary for various reasons
during production, such as the need for more raw materials, labor or equipment to
complete an order.
To create a variable costing income statement, follow the steps below:
1. Compile your revenues
Revenue = number of products sold x price per product
2. Determine your variable production expenses
Total variable production expenses = variable cost of goods sold + variable selling
expenses
3. Calculate your contribution margin
Contribution margin = total sales revenue - variable production expenses
4. Subtract your fixed production expenses
Net income = contribution margin - fixed production expenses
5. List all calculations in a single document
3.2 The Absorption Costing Income Statement
 Absorption costing is also known as full costing. Public companies are required
to use the absorption costing method in cost accounting management for their
COGS. Many private companies also use this method because it is GAAP-
compliant whereas variable costing isn't.
 Absorption costing involves allocating all of the direct costs associated with
manufacturing a product to COGS. This includes any variable costs directly
associated with manufacturing, such as:
 Cost of raw materials
 Hourly cost of labor
 Salaries of manufacturing workers
 Variable costs of electricity used to run a plant in manufacturing mode
This also includes any direct fixed costs, such as:
  The mortgage payment on a building used for manufacturing
 Insurance on a manufacturing property
 Depreciation on a manufacturing machine
Income Statements
The income statements are different under the two costing method to account for the
differences in the treatment of fixed manufacturing overhead.
• The absorption costing income statement follows a more traditional format of
computing gross profit first and then subtracting operating expenses.
• Variable costing uses the Contribution Margin format and separates cost
based on their behavior (fixed and variable).
3.3 The Normal Capacity
Normal capacity is the amount of production volume that can be reasonably expected
over the long term. Normal capacity takes into account the downtime associated with
periodic maintenance activities, employee vacations, crewing problems, and so forth.
When budgeting for the amount of production that can be attained, normal capacity
should be used, rather than the theoretical capacity level, since the probability of
attaining normal capacity is quite high. The normal capacity level can decline over time
as production equipment ages, since the equipment requires more maintenance effort.
3.4 Absorption vs Variable Costing
The difference between absorption costing and variable costing is how fixed
manufacturing overhead is treated.
 Under absorption costing, fixed MOH is treated as a product cost, it goes into
inventory when it is incurred and is included in the calculation of Cost of Goods
Sold.
 Under variable costing, fixed MOH is treated as a period cost and is expensed
on the income statement when it is incurred and is not included in the
calculation of Cost of Goods Sold

3.5 Cost Segregation Techniques

 A cost segregation study is a process that looks at each element of a property, splits
them into different categories, and allows you to benefit from an accelerated
depreciation timeline for some of those building components.
The Cost Segregation Audit Techniques Guide has a chapter devoted to the six
common approaches that may be used when performing a cost segregation study.
The six methods do not provide the same level of value, reliability, or accuracy. In fact,
the approaches are presented in descending order of value and accuracy as a
reference to how an examiner reviews a cost segregation report.
Common Approaches for Cost Segregation Studies:
1. Detailed Engineering Approach from Actual Cost Records
2. Detailed Engineering Cost Estimate Approach
3. Survey or Letter Approach
4. Residual Estimation Approach
5. Sampling or Modeling Approach
6. Rule of Thumb” Approach
3.6 High-low Method
A way of attempting to separate out fixed and variable costs given a limited
amount of data.
 In cost accounting, the high-low method is a way of attempting to separate out
fixed and variable costs given a limited amount of data. The high-low method
involves taking the highest level of activity and the lowest level of activity and
comparing the total costs at each level.
 If the variable cost is a fixed charge per unit and fixed costs remain the same, it
is possible to determine the fixed and variable costs by solving the system of
equations. It is worth being cautious when using the high-low method, however,
as it can yield more or less accurate results depending on the distribution of
values between the highest and lowest dollar amounts or quantities.
Understanding the High-Low Method
Calculating the outcome for the high-low method requires a few formula steps.
First, you must calculate the variable cost component and then the fixed cost
component, and then plug the results into the cost model formula.
First, determine the variable cost component:

Where:
 HAC=Highest activity cost
HAUs=Highest activity units
Variable cost is per unit

Next, use the following formula to determine the fixed cost component:

Use the results of the first two formulas to calculate the high-low cost result using
the following formula:

Where:
UA=Unit activity

3.7 Scatter-graph Method

The scatter graph (or scatter graph) method is a visual technique used in accounting
for separating the fixed and variable elements of a semi-variable expense (also called
a mixed cost) in order to estimate and budget for future costs. A semi-variable
expense is more complicated to analyze since it is made up of both fixed and variable
factors.
A scatter graph uses a horizontal x-axis that represents a firm's production activity and
a vertical y-axis that represents its cost. Data are plotted as points on the graph, and a
regression line that runs through the dots represents the best fit of the relationship
between the variables.
3.8 The Least Squares Method
The least-squares method can be defined as a statistical method that is used to find
the equation of the line of best fit related to the given data. This method is called so as
it aims at reducing the sum of squares of deviations as much as possible. The line
obtained from such a method is called a regression line.
Formula of Least Square Method
The formula used in the least squares method and the steps used in deriving the line
of best fit from this method are discussed as follows:
Step 1: Denote the independent variable values as xi and the dependent ones as yi.

Step 2: Calculate the average values of xi and yi as X and Y.

Step 3: Presume the equation of the line of best fit as y = mx + c, where m is the slope
of the line and c represents the intercept of the line on the Y-axis.
Step 4: The slope m can be calculated from the following formula:
m = [Σ (X – xi)×(Y – yi)] / Σ(X – xi)2
Step 5: The intercept c is calculated from the following formula:
c = Y – mX
Thus, we obtain the line of best fit as y = mx + c, where values of m and c can be
calculated from the formulae defined above.

Least Square Method Graph

The red points in the above plot represent the data points for the sample data
available. Independent variables are plotted as x-coordinates and dependent ones are
plotted as y-coordinates. The equation of the line of best fit obtained from the least
squares method is plotted as the red line in the graph.
We can conclude from the above graph that how the least squares method helps us to
find a line that best fits the given data points and hence can be used to make further
predictions about the value of the dependent variable where it is not known initially.
Limitations of the Least Square Method
The least squares method assumes that the data is evenly distributed and doesn’t
contain any outliers for deriving a line of best fit. But, this method doesn’t provide
accurate results for unevenly distributed data or for data containing outliers.