This is the sample code

use XML::DOM;
use strict;
use File::Find;
use XML::SAX;
use XML::SAX::Writer;
use XML::Filter::XInclude;
use File::Copy;
use IO::File;

my $output = new IO::File "> output.xml";
my $parser = XML::SAX::ParserFactory->parser(
     Handler => XML::Filter::XInclude->new(
        Handler => XML::SAX::Writer->new(Output=>$output)
     )
);
$parser->parse_uri("./project.xml");
[download]

output.xml has a has some data and also has a xinclude, ie reference to another file in another location. As of now the paths are absolute, but can it support any variable?

I'm not sure if I understand you correctly. Sure you can use variables instead of hardcoding the paths. You can also use Perl environment variables by using %ENV. Try the code below to get an overview.

use strict;
use warnings;

foreach my $key (keys(%ENV)) {

    printf("%-10.10s: $ENV{$key}\n", $key);

}
[download]

Output on my system (slightly edited)

HOME      : /Users/dharry
LOGNAME   : dharry
DISPLAY   : /tmp/launch-uz3Zcp/:0
COMMAND_MO: unix2003
VERSIONER_: no
PATH      : /usr/bin:/bin:/usr/sbin:/sbin
APP_ICON_2: ../Resources/Eclipse.icns
SHELL     : /bin/bash
JAVA_START: 1
SSH_AUTH_S: /tmp/launch-tK7iUz/Listeners
Apple_PubS: /tmp/launch-SmQdNX/Render
TMPDIR    : /var/folders/F9/tmp/
USER      : dharry
VERSIONER_: 5.10.0
[download]

You can also set certain variables like LOGDIR.

Cheers

Harry

Update

Missed something the first time I read the post.

When i try to invoke the xinclude parser, it is not able to access the file even though i initialize the variable with a pre-determined path.

Does the variable contains what you think it does? Does the parser throw an error? Try adding use warnings as well. At first glance I see no reason why it shouldn't work.