Variable Cost: What Is It and How Do You Calculate It?
A variable cost is an expense or outgoing that changes in value. Factors that can influence the value include sales revenues and company output. Examples of variable costs include labor, distribution expenses, and supplies and materials.
A variable cost will either increase or decrease depending on sales and output. Costs will rise in line with increased production and fall when output decreases.
Variable Costs vs. Fixed Costs
Variable costs are often discussed in the context of comparing variable and fixed costs. While variable costs change as production or sales volume increase or decrease, fixed costs remain the same.
Companies typically incur both fixed and variable expenses. It’s essential to understand how to calculate variable costs to budget and forecast effectively.
Fixed costs will remain unchanged regardless of how much the company produces or sells. Whether your business makes a huge number of sales or you struggle to close deals, the value of fixed expenses will stay the same. Examples of common fixed costs in business include rent, business insurance, and workplace supplies.
It is important to note that fixed costs can vary, but production is not the element influencing their value. External factors, including market value and demand, can push rental prices up, for example.
To illustrate the difference between fixed and variable costs, consider this example. A business that produces flasks for hot drinks pays a fixed cost of $2,000 per month for rent. The cost of making the flask is $3. If the company sells 100 flasks, the variable cost will be $300.
If production increases and the business receives an order for 1,000 units, the variable cost will increase to $3,000. If sales fall, and the business receives no orders, the variable cost will fall to $0.
In all these scenarios, the fixed cost will remain at $2,000 per month. The cost of renting premises will not vary depending on output.
How To Calculate Variable Costs
Financial issues are among the most common causes of business failure. Balancing the books is a key objective for company owners across all sectors.
To regulate spending and draw up suitable, accurate budgets and maximize profits, businesses need to be aware of the expenses they’ll have to cover. To calculate variable costs, you can use this simple variable cost formula:
Total Variable Cost = Total Quantity of Products (also known as Total Quantity of Output) x Variable Cost per Unit
To better understand how this formula works, let’s consider another example. If a company that provides pet supplies receives an order for 200 dog toys for $20 each, but the product costs $10 to make, the variable cost will be $10, and the profit will be $10.
The total variable cost will be the number of products in the order, in this case, 200, multiplied by the variable cost of each unit. This means that the calculation for the pet company is 200 x 10 to produce a total variable cost of $2,000.
What Is the Average Variable Cost?
The average variable cost uses the total variable cost calculation to determine how much, on average, it costs to produce each unit. The average variable cost is not always the same as the total variable cost for each product because it takes the variable costs per unit of different products into account.
If Product 1 has a variable cost of $10 per unit and Product 2 has a variable cost of $5 per unit, for example, the calculation for the average cost will combine the figures.
The formula for average variable costs is:
(Total Variable Cost of Product 1 + Product 2) / Total number of units
For the example above, if you sold 20 units of product 1 and 10 units of product 2, the calculation would be $10 x $20 plus $5 x $10 divided by 30 (total units sold). The average cost would be $8.30.
Examples of Variable Costs
Businesses may encounter many types of variable expenses and costs. Common variable costs examples include:
- Raw materials. Also known as direct materials costs, this is one of the most significant variable costs for businesses that manufacture products. The cost of buying raw materials will increase in line with rising demand for products. If you need to make or order more supplies because orders are flooding in, your total variable cost will rise.
- Production supplies. The quantity of supplies your business requires to create products and fulfill orders will rise and fall depending on the number of products you sell. If sales are increasing, the cost will rise because you need more supplies. If sales have slumped, variable costs will fall because the quantity of supplies required will decrease.
- Labor. If you pay employees per unit, known as piece rate labor, your variable costs will increase and decrease depending on how many units are produced.
- Sales commission. Many companies offer their employees the opportunity to earn commission on sales. Commission is classed as a variable cost because the amount you pay in commission or bonuses will vary according to sales performance. Employee earnings will increase in line with rising sales linked to commission, which increases the company’s variable costs.
- Transaction fees. If you accept payments through methods that carry a transaction fee, for example, credit card payments, you’ll pay more as the number of transactions increases.
- Flexible contracts. Some companies employ workers on a flexible basis, which means they pay per day or hour. If this is the case, variable labor costs will rise when workers record more hours and fall during quieter periods.
- Utilities. Utility bills will often rise as a result of increased energy usage required to ramp up production. If you receive a large order, for example, your electricity bill is likely to increase as your business will be producing more units.
- Gas and travel expenses. If you pay staff travel expenses or you operate a fleet of vehicles, the cost of gas and travel will rise if production or sales volumes increase.
- Distribution and shipping. Many businesses ship products to customers. Distribution and shipping are variable costs, which will increase and decrease according to sales volume and order numbers. The more items you need to ship or distribute, the higher the variable cost.
Variable costs will often differ between businesses operating within different industries. For this reason, it’s often unhelpful to compare the variable costs of companies in different sectors, for example, a company that manufactures TV sets and a car manufacturer.
It’s more useful to compare variable expenses between companies that are likely to incur similar costs, for example, two car manufacturers.
How Does Variable Cost Affect Profitability?
In business, it’s essential to be able to balance your variable expenses. If the cost of production soars and is greater in value than the profits generated by increased production, your business won’t be profitable even if order numbers are rising.
The key to growing a business lies in being able to scale up in a way that increases profits. The higher the variable costs, the lower the chances of making profits.
Industries with high fixed costs, for example, airlines, are generally considered to be less vulnerable to competition within the market because they need a huge amount of investment to get off the ground.
In contrast, businesses with high variable costs, for example, hospitality ventures, are more vulnerable to competition because they are relatively inexpensive to launch.
In many cases, variable and fixed costs are black and white, and it’s easy to determine what type of cost business expenses fall into. There are some gray areas, though. Common examples include rent and salaries.
Rent can be a gray area because rates can rise and fall. In the context of the definition of variable costs, rent is considered a fixed cost. This is because the cost of renting premises will not go up or down depending on the productivity or output of the business.
The cost of renting a warehouse or a store, for example, may increase, but this will be due to other factors that are not directly linked to output or sales. In most cases, price changes will reflect movements in the market.
Salaries are fixed costs, but labor can be a variable cost. If you have a salary, this is calculated at a basic rate, which is fixed for a set term. Your salary will be classified as a fixed cost if you are an employee and you have an employment contract, which specifies a set wage per year.
If you earn commission or performance-related bonuses, or you work on a flexible basis and you charge an hourly rate or a day charge, this is different. In this case, labor is a variable cost because workers will earn more if production increases, they hit targets or make sales, or they work more hours. They’ll earn less in commission or wages if sales fall or they work fewer hours.
A variable cost is a cost that changes in line with increased or decreased sales volume or output. Examples of variable costs include labor, distribution and shipping, supplies, and raw materials.
What are variable costs also known as?
Variable costs are also known as variable expenses. A variable cost will rise and fall depending on sales and production, while fixed costs remain the same.
Is rent a variable cost?
Rent is usually considered a fixed cost because it doesn’t change as a result of production or output. If rental fees rise or fall, this is usually due to factors not directly linked to company output.
Which are fixed costs?
Examples of fixed costs for businesses include salaries, rent, business insurance, property taxes, and office supplies.
For years, the clients I worked for were banks. That gave me an insider’s view of how banks and other institutions create financial products and services. Then I entered the world of journalism. Fortunly is the result of our fantastic team’s hard work. I use the knowledge I acquired as a bank copywriter to create valuable content that will help you make the best possible financial decisions.
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