Variable costing is a method of product costing in which only the costs that vary with production, direct materials, direct labor and variable manufacturing overhead, are treated as product costs and included in inventory. Fixed manufacturing overhead, such as factory rent and supervisors' salaries, is charged in full as an expense in the period it is incurred. Variable costing is another name for direct costing, which explains the method in more detail, and it is also called marginal costing.
How the term is used
Variable costing is mainly a tool of managerial accounting. It produces an income statement in the contribution format, where variable costs are subtracted from sales to show the contribution margin, and fixed costs are deducted afterward. This makes it easy to see how profit responds to changes in volume and supports break-even and pricing decisions.
It contrasts with absorption costing, which includes fixed manufacturing overhead in the cost of each unit and is required for external reporting under US GAAP and IFRS and for US income tax. When production exceeds sales, absorption costing reports higher profit because part of the fixed overhead is carried forward in inventory; under variable costing, profit moves with sales rather than production. For example, if fixed overhead is $200,000 and a company makes 10,000 units but sells 8,000, absorption costing defers $40,000 of that overhead in ending inventory, while variable costing expenses all $200,000. Managers therefore often use variable costing internally to avoid rewarding overproduction.