The most common error made by business owners is to use this term in financial accounting. I don’t recommend using variable costs in financial accounting unless you qualify its usage. You should have a true in-depth understanding of related terms such as fixed costs, sunk costs, mixed costs, depreciation, overhead accumulation and the associated overhead allocation. So for those of you that are novices or intermediate level business owners, it would be best to stick to using the term with cost accounting until you gain the appropriate knowledge.
This article is a basic introduction to the term. I will provide the technical definition and appropriate application. In addition, I’ll provide two simple examples of its use leading up to a more comprehensive example. Finally, I’ll touch base and introduce the reader to its complexity when used with financial accounting so that you can appreciate limiting its use to cost accounting.
Technical Definition and Application
Back in college, my cost accounting course defined variable costs as those expenditures that changed in direct proportion to the change in production. So if production increases, those costs that increase with production are variable in nature, i.e. linked to the change in production. As a continuation of this concept, if production decreased, then those costs that decreased with this change are also variable. The best examples are raw materials and labor. Assuming labor is on demand, if the production run is ramped up then the raw materials, labor, energy, packaging and distribution related costs would increase too. However, some costs will not change such as rent for the warehouse or the lease payment for the production equipment.
Those costs that have no change related to production within a relevant range are considered fixed costs. To fully appreciate variable costs, please read my article about fixed costs. Earlier I stated that variable cost is a cost accounting term. It is used to identify the overall production cost related to a change in volume. All of us in the business world generally associate any increase in production or sales as good thing. After all, that is one of reasons we are business, to make more money. However, in cost accounting the goal is to identify issues that cause a non-linear increase or decrease in costs. Again, if volume increases you would think the average cost per unit would decrease. But often this is not true. Sometimes there is a significant increase in the variable costs of production related to either the increase in raw materials or labor. A good example is receiving your raw materials via the transportation medium (trucking, rail or direct delivery) but if you increase the demand beyond the capacity of the delivery mechanism then a second deliver system must be used. Often the second medium is more expensive than the first or marginally more expensive.
The goal of cost accounting is to identify the cost drivers of production. Variable costs are some of the types of costs in production. By understanding the variable costs, the accountant can then identify the breakeven points for production runs and help the company determine the profitability of manufacturing or rendering service. So if the owner of the company knows his fixed costs and the variable costs, he can then use this knowledge to understand how many units he must sell to breakeven or earn a required level of margin or even profit.
Let’s use this concept of understanding cost accounting and the variable costs and find out how many widgets we must produce to cover fixed costs. Unlike in example ‘A’, the variable cost is indeed linear in nature to production. That is, it remains constant per unit no matter how many units we produce.
From this information, can we determine the maximum profit if we produce all one million rolls in a month? The answer is yes, the contribution dollar per unit is 9 cents. With 1 million rolls produce, we earn a total of $90,000 (1,000,000 * .09 each). If we subtract fixed and overhead costs of $56,000 it leaves us with a profit of $34,000. $34,000 is our maximum profit given our production run and associated costs (variable, fixed, overhead).
Now you see how variable cost is used in cost accounting to help management make decisions. From the above example, management can explore other issues or variables to help maximize profitability. A good example is adding some more fixed costs and reducing variable costs and recalculate to see if we could earn more profit.
But suppose that we can only sell as a guarantee, 650,000 units per month. Would it be wise to make the change? Answer: .0021 times 650,000 equals $1,365 more contribution margin which easily covers the additional $900 of costs. So still a good decision at this level of production.
Now you get an understanding of the application of variable costs in cost accounting. Remember I stated above that variable cost is used in cost accounting and only those that have a true understanding of the relationship with other costs accounting terms can understand the use of the term with financial accounting.
Using Variable Costs in Financial Accounting
Financial accounting is more complex than cost accounting as financial accounting reports the outcome after the fact. That is, financial accounting records the economic activity over a period of time. It reports this volume of activity and then illustrates the change in financial position during this time period. Cost accounting is used to make production decisions whereas financial accounting is a record of the financial outcomes from those production decisions. The scope of activity is broader in financial accounting as it incorporates all the general and administrative costs including human resources, marketing, management, legal and compliance costs. Cost accounting restricts itself to production costs and for the most part excludes the general and administrative costs. Advanced cost accounting can use overhead pooling and allocation formulas to include these respective expenses.
The problem is that variable cost is frequently used by the novice or less informed businessmen in discussing or explaining financial information. The most common mistake is equating the costs of goods sold as variable costs in a company’s financial reports. This may appear correct as they seem similar. Remember, variable costs change with production. Well, costs of goods sold change with the volume of sales. So why are they not the same thing? Answer: Cost of Goods Sold is a function of sales and the difference equates to gross margin. Gross margin is used to cover fixed and operational costs. In production, variable costs are used to determine the contribution margin per unit which then is used to identify the level of production needed to cover the fixed costs. In cost accounting, we assume we can sell the entire production run. This is not true in financial accounting.
In addition, cost of goods sold can include some costs not normally equated to variable costs with production. These costs relate to various non-production related issues and include:
- Human Error – with purchasing; failing to order materials in a timely manner necessitating additional fees to maintain proper delivery and timing of raw resources
- Early Pay Discounts – some industries include early pay discounts in the costs of materials or supplies and therefore in costs of goods sold whereas this value is not included in cost accounting
- Labor Benefit Costs – there is often a significant difference in dollars between the amounts used in calculating labor costs for cost accounting and those assigned to cost of goods sold
But the most likely difference between the two types of accounting for variances relates to product mix sold in the market. With cost accounting, it is designed for a single production run of a particular product; using our example above, simple single ply toilet paper. But in reality, cost of goods sold relates to a multitude of products sold and the costs associated with those different pools of items. So if we continue using toilet paper as the example, the financial statement will report the sales and costs of goods sold related to:
- Single Ply
- Two Ply
- Two Ply Cotton Soft
- Two Ply Extra Soft
- Two Ply w/Aloe
You get the idea.
My point is that variable costs are not equal to costs of goods sold. Variable costs are cost accounting issues and cost of goods sold is a financial accounting matter.
Summary – Variable Costs
Variable cost is synonymous with one of the types of accounting known as ‘Cost Accounting’. It is frequently used in financial accounting by novice businessmen that mistakenly apply variable costs as a concept of accounting in general. Variable costs are those costs that change in relation to production whether up or down. You may use the term in financial accounting but please be aware of its limitations and gain an understanding of the related terms such as fixed, mixed, sunk and overhead costs. Act on Knowledge.
If you have any comments or questions, e-mail me at dave (insert the usual ‘at’ symbol) businessecon.org. I would love to hear from you.