Variable costs are expenses that change. Many business costs vary in proportion to production. In other words, if a business increases its product volume, its costs will increase accordingly. Conversely, costs increase and decrease as production volume increases or decreases. Some businesses’ most common variable costs include materials, labor, transaction fees, commissions, and utility costs. These types of costs fluctuate based on the company’s activity volume.
There is a formula to help businesses plan for variable costs. To calculate variable costs, multiply the total quantity of units output by the variable cost per unit. The formula is:
Total Quantity of Output (times) Variable Cost Per Unit of Output = Total Variable Cost
The sum of all the manufacturing overhead and variable costs will yield the total cost of manufacturing products or services provided.
What is a Variable Cost?
The variable cost for a business is the expense incurred in proportion to production output or sales. Variable costs differ from fixed costs, which do not change in relation to sales volume or production. Variable costs are based on and depend on sales or production output. When production volumes increase, variable costs will increase as well. On the other hand, when fewer products are produced, the associated variable costs will decrease as well.
Why is Variable Cost Important?
When it comes to making managerial decisions, variable costs are indispensable. They are relevant and require management to be directly involved, unlike fixed costs that are irreversible and incurred automatically. Assessing variable costs is important to making profitability comparisons when looking at different units within a business’s production.
Businesses need to consider variable costs since they greatly impact how money is spent. A company’s strategic goals can cause variable costs to be extremely high or very low. When variable costs are low, businesses have more budget to spend on other areas where no sudden cost is incurred.
How Does Variable Cost Affect Value?
Investors are more likely to value a company higher if they have more variable costs and fewer fixed costs. Variable costs give the business more control over profitability and its bottom line. This can boost a company’s valuation. Controlling the bottom line involves predicting variable cost fluctuations and finding ways to reduce them to improve their gross margin and profit.
What are the Advantages of Variable Cost?
There are several advantages of variable cost. For instance, it provides management with the margins needed for daily decisions like expansions, special orders, or shutting down production. Managers can better understand how period costs impact profits. Manufacturers use variable costs to help with budgeting. It’s also useful for helping assess changes in profitability.
What Effect Do Variable Costs have on Growth and Profitability?
In business, balancing variable costs is essential. If the cost of production increases above the profits that are generated, the business won’t be profitable even though orders increase. The key to balance is being able to scale up in a way that increases profitability rather than cutting into it. The higher variable costs rise, the lower the chances of making a profit.. Airlines are an example of high fixed costs. These types of operations are not as vulnerable to competition inside the market. But they need a large investment to get started. On the other hand, businesses that have high variable costs are more vulnerable to competition even though they are less expensive to launch.
What are Examples of Variable Costs?
Different industries and businesses vary in their types of variable expenses and costs. Their variable costs will depend on if they sell physical products, digital products, or services. Some of the most common examples of variable costs include.
- Raw Materials. Raw materials are also known as direct materials costs. Businesses that manufacture products spend a significant amount of money buying raw materials. The cost of raw materials directly increases when the demand for products increases. When people or businesses are ordering more products, the manufacturer naturally needs more materials to make them. This will cause their total variable costs to rise.
- Labor. When employees are paid per unit, it is called piece rate labor. The variable costs will fluctuate depending on how many units workers produce.
- Production Supplies. The amount a business pays for supplies to create products and fulfill orders fluctuates based on how many products are sold. When sales increase, costs rise because more supplies are needed. When sales slump, variable costs decrease because not as many supplies are needed.
- Distribution & Shipping. Businesses that ship products to customers will have variable costs for distribution and shipping. These costs rise and fall based on the sales volume and how many orders are being filled. The more items the business distributes, the higher the variable cost.
- Transaction Fees. Businesses usually have to pay transaction fees to accept electronic payments via debit or credit cards. When business is booming, the number of transactions will increase, which will drive up these variable costs.
What is the Formula of Variable Cost?
The formula of variable cost is a specific algorithm used to calculate the total variable cost. The formula is Total variable costs = the total number of a product (or service sold) times the variable cost per unit. For example, say a business sells shoes, and they sold 800 pairs of shoes last month. Each pair of shoes costs the business $20. So, the cost per unit is $20. The variable cost is found by multiplying 800X$20. Therefore, the total variable costs were $1600.
What is the Average Variable Cost Formula?
The variable cost is important when calculating the average variable cost. The average variable cost gives a business a good idea of how much it costs to produce each product. The variable cost is not always the same as the total variable cost for each item since it considers the variable cost per unit for different products. The formula used to find the average variable cost is:
The total variable cost of Product 1 plus Product 2 / total number of units
For example, if the variable cost for product 1 is $10 per unit and the variable cost for product 2 is $5 per unit, then the two are combined in the first step. Let’s say a business sold 20 units of product 1 and just ten units of product 2. Then the calculation would be ($10 x $20) +($5 x $10) divided by 30 total units sold. The average variable cost is $8.30.
What is Variable Cost per Unit?
Variable costs per unit are the manufacturing expenses incurred to produce just one unit. The costs will vary directly with production levels. Variable costs relate directly to the changes in output, increasing as production grows and decreasing as production slows.
What Happens to Variable Cost When Production Increases?
Any change in demand affects sales. Sales directly impact variable costs. As sales increase, production needs increase, driving the variable costs associated with production up. For instance, if a company needs to create more products, it will need more raw materials to do so. Other variable costs like utilities, factory overhead, replacement parts, and supplies vary with fluctuations in the market. So when production increases, variable costs will increase as well.
What is the Difference Between Fixed and Variable Costs?
Fixed costs usually stay the same over time. They are costs a business can count on to remain the same. Common examples include rent or mortgage payments, equipment rentals, and salaries for managerial staff. Variable costs tend to change and have no set value. Some examples of variable costs include utilities, gas for vehicles, labor costs, and production costs. Fixed costs remain the same whether production output increases or decreases. Variable costs fluctuate based on how much output is produced.
Is Labor a Variable Cost?
It depends. Every business has a “bare bones” crew or the minimum number of hourly employees needed to keep the doors open. Most labor costs are fixed expenses rather than variable costs. Salaries that remain the same, whether production increases or decreases, would be classified as a fixed cost. But hourly wages that increase as production picks up would be a variable cost. Labor costs that fluctuate in response to production or sales are variable. But labor costs that remain the same all the time are fixed costs.