Using direct or variable costing reported net income does not move in the same direction as sales

The variable costing income statement is one where all variable expenses are subtracted from revenue, which results in contribution marginThe contribution margin is a metric that shows how much a company's net sales contribute to fixed expenses and net profit after covering the variable expenses. As a result, we deduct the total variable expenses from the net sales when computing the contribution.read more. From this, all fixed expenses are subtracted to arrive at the net profit or loss for the period. It is useful to determine the proportion of expenses that varies directly with revenues.

In many businesses, the contribution margin will be substantially higher than the gross margin because such a large amount of its production costs are fixed, and a few of its selling and administrative expenses are variable.

The formula for Net profit or loss is:-

• Contribution Margin =Revenue – Variable Production Expenses – Variable Selling and administrative expenses
• Net profit or Loss = Contribution Margin – Fixed production expenses – Fixed Selling and administrative expenses

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For eg:
Source: Variable Costing Income Statement (wallstreetmojo.com)

Examples of Variable Costing Income Statement

Example #1

A company named ABC Cotton sells cotton for $30 per Kg. The data for the year 2016 is given below:-

• Sales in Kg- 80,000 kgs
• Finished goods inventory at the beginning of the period- 15,000 kgs
• Finished goods inventoryFinished goods inventory refers to the final products acquired from the manufacturing process or through merchandise. It is the end product of the company, which is ready to be sold in the market. read more at the closing of the period-20,000 kgs

Manufacturing costs-

• Variable costs- $10 per Kg
• Fixed manufacturing expense cost- $ 3,00,000 per year

Marketing and administrative expenses-

• Variable expenses- $5 per kg of sale
• Fixed expense- $2,50,000 per year

Through the above information, we have prepared a variable cost income statement.

Example #2

Let us understand how this statement is prepared.

Sales are calculated, which is a total sale in kgs, i.e., 80000 multiplied by per kg cost, i.e., $30.

=Total Sale*Rate per kg

Calculate variable Opening Inventory

Opening Inventory is finished goods inventory at the beginning of the period, i.e., 15000 kgs multiplied by manufacturing variable cost, i.e., $ 10. So,

= finished goods inventory at the beginning of the period* manufacturing variable cost

The variable cost of manufactured goods is

=(Total sale + Finished goods inventory at the closing of the period – Finished goods inventory at the beginning of the period)*manufacturing variable cost

The variable cost of good available for saleThe cost of goods available for sale refers to the cost of total goods produced during the year after accounting for the cost of finished goods inventory at the beginning of the year and is available for sale to the end-users.read more

=Variable cost of manufacturing goods + Opening Inventory

Calculate the closing inventory that is

=Finished goods inventory at the closing of the period* manufacturing variable cost

Now, we will get the Gross contribution margin.

Gross contribution margin = Total Sales – Variable cost of goods available for sales – closing inventoryClosing stock or inventory is the amount that a company still has on its hand at the end of a financial period. It may include products getting processed or are produced but not sold. Raw materials, work in progress, and final goods are all included on a broad level.read more

Calculate variable marketing and administration expenses, which is

=Total sale*Variable Marketing and administrative expenses

Contribution margin calculated i.e.

=Gross contribution margin – variable marketing and administration expenses

Now, we have to calculate fixed expenses

= Fixed manufacturing expense cost + Fixed marketing and administrative expenses

Finally, we will get net operating income

= Contribution margin – Fixed expenses

Total Production during year = Total sales + Closing inventory – Opening Inventory

Manufacturing expenses per unit=Variable expense + Fixed Expense

Hence, we found that net operating incomeNet Operating Income (NOI) is a measure of profitability representing the amount earned from its core operations by deducting operating expenses from operating revenue. It excludes non-operating costs such as loss on sale of a capital asset, interest, tax expenses.read more with variable costing income principle.

Normal Income vs. Variable Costing Income Statement

1. The Normal income statementThe income statement is one of the company's financial reports that summarizes all of the company's revenues and expenses over time in order to determine the company's profit or loss and measure its business activity over time based on user requirements.read more has a gross margin, whereas variable costing income statements have a contribution margin.
2. In variable costing income statements, all variable selling and administrative expenses are a group with variable production costs. It is a part of the contribution margin.
3. All fixed production costs aggregate lower in a statement after the contribution margin in variable costing income statements.

The key difference between gross margin and contribution margin is that in gross margin, fixed production costs are included in the cost of goods. Whereas in contribution margin, fixed production costs do not include in the same calculation. This means that variable costing income statements are sorted based on the variability of the underlying cost information rather than by functional areas or expenses categories found in a typical income statement.

Under both statements, the net profit or loss will be the same.

Advantages

• Variable cost provides a better understanding of the effect of fixed costs on the net profit in variable cost income statements.
• Companies get the necessary income for cost volume profit (CVP) analysisCost Volume Profit Analysis (CVP) is a way to understand the relationship between cost & sales and profit. It determines the effect of change in cost and sales on the profit of the company.read more. Management cannot extract this data from traditional methods.
• The net operating income figure is close to the flow of cash. It is useful for businesses that face problems in cash flowCash Flow is the amount of cash or cash equivalent generated & consumed by a Company over a given period. It proves to be a prerequisite for analyzing the business’s strength, profitability, & scope for betterment. read more.
• Other methods change with a change in inventory level, period, etc. Sometimes sales and income move in the opposite direction, but this does not happen in the variable cost method.

Disadvantages

• The variable cost income statement is not per the GAAP standard (Generally accepted accounting principle).
• The tax law of many countries uses other method statements like absorption costing.
• It does not assign a fixed cost to a unit of productionFixed Cost refers to the cost or expense that is not affected by any decrease or increase in the number of units produced or sold over a short-term horizon. It is the type of cost which is not dependent on the business activity.read more. Hence, a production cost cannot be matched with revenueRevenue is the amount of money that a business can earn in its normal course of business by selling its goods and services. In the case of the federal government, it refers to the total amount of income generated from taxes, which remains unfiltered from any deductions.read more.

Variable cost-income statements help companies in various analyses like cost volume profit, prepare flexible budgetsA flexible budget refers to an estimate which varies with the change in production activity or volume. Such a budget is more realistic and flares the managerial efficiency and effectiveness as it sets a benchmark for the actual corporate performance.read more for better variance analysis and help in decision making to accept or reject special orders.

Recommended Articles

This has been a guide to Variable Costing Income Statement. Here we discuss steps to prepare the variable costing income statement along with practical examples and its advantages and disadvantages. You may learn more about Accounting from the following articles –

• Absorption Costing Formula
• Income Statement Basics
• Differences between Contribution and Gross Margin
• Explain Direct Costs