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So, after rewatching this episode I think it makes sense. I really don't need to post this, but I think I need to type it out so I can work through it in my own head. Feel free to ignore/mock me.

The afternoon in this episode, the afternoon of the incident, is November 5, 1955 so to speak. Everything we've ever seen on this show originates with this day and event. So, Daniel is probably right that he's a variable, but he's probably wrong that Kate, Jack and Hurley are variables. I think that they were always supposed to be there.

So, if variable Daniel implements his bomb plan, he will undo everything that's ever happened on this show and destroy the "space time continuum". Therefore at some point, Ellie is warned that a crazy wild-eyed scientist is going to burst into camp and she must kill him before he destroys the universe. Who delivers this warning, I don't know. They can let Kate and Jack live because as non-variables, their attempts to implement Daniel's plan will naturally fail.

Of course Ellie soon learns she kills her son, but must allow it to happen so he doesn't destroy time.

The only flaw in this plan is that she could have just let little Daniel continue playing the piano and end up on Star Search instead of the island. But I guess that would be no fun.