Variable Cost: What It Is and How to Calculate It
What exactly is a Variable Cost?
It is a business expenditure that directly affects how much a firm produces or sells. Variable costs rise or fall concerning a company's production or sales volume, rising as production grows and falling as production drops. Variable costs usually include raw materials and packaging for a manufacturing firm or credit card transaction fees and shipping expenditures for a retail company, which climb and fall with sales. A variable cost is distinguished from a fixed cost.
In-Depth Understanding of Variable Costs
Any company's overall expenses are made up of variable and fixed costs. Variable costs are those that are affected by manufacturing output or sales. The variable cost of production is a fixed sum per unit manufactured. These costs will rise as the amount of production and output rises. When fewer items are produced, the variable costs associated with manufacturing fall accordingly.
Variable cost instances include sales commissions, direct labour costs, the cost of raw materials used in manufacturing, and utility prices.
Variable costs are typically considered short-term costs since they may be readily modified. For example, if a corporation is experiencing cashflow problems, it may instantly change the output to avoid incurring these costs.
Variable Costs Formula and Calculation
One needs to simply multiply the quantity of output by the variable cost per unit of production to get the total variable cost. The formula can be written as below:
Total Variable Cost = (Total Output Quantity) X (Variable Cost per Unit Output)
Profits will affect the variable cost per unit. Generally, it is frequently estimated as the total of the many variable costs; they are outlined in the next section below. If variable costs are incurred in batches, they may need to be distributed among commodities (i.e. 100 pounds of raw materials are purchased for manufacturing 10,000 finished goods).
Variable Cost Types
Specific items/products in the manufacturing process are often considered variable costs. Consider the production and delivery procedures for a prominent athletic or sports manufacturer as the common example for the variable costs mentioned below:
Materials for Production
Raw materials are direct purchases that are eventually transformed into a finished product. Suppose the sports brand does not manufacture the shoes. In that case, it will not have to pay for leather, synthetic mesh, canvas, or other relevant raw materials. That means the raw materials remain the same for any specific item or product. In principle, assuming no substantial changes in producing one unit against another, a corporation should spend about the same amount on raw materials for each item made.
The sports firm will only accept various forms of labour if it yields more outstanding production. Some employees may be salaried; whether the output is 100,000 or 0 units, such employees will be paid the same fixed amount. However, the company may need to pay more to other workers who are paid on an hourly basis because they may put in additional direct labour hours.
Commissions are often a portion of a company's sales revenues provided as additional pay. There is no commission charge if no sales are made. Because commissions fluctuate per whatever underlying criteria the salesperson must meet, the cost fluctuates (i.e., is variable) with activity level.
When the manufacturing line starts turning on equipment and ramping production, it uses energy. When it comes to finishing a project and shutting everything down, utilities are frequently not consumed. In this way, utilities are also variable with production. As a corporation seeks to enhance production, this extra effort will likely need more power or energy, increasing variable utility costs.
The cost of packaging or shipping a product will only be incurred if specific activities are carried out. As a result, the cost of delivering a finished object varies according to the number of units transported. Although specific shipping expenses are fixed (for example, an in-house mail delivery network with a tailored weighing and packing product line), many ancillary costs are still variable.
The Significance of Variable Cost Analysis
Variable costing data may be used to examine expenditures, pricing, and profitability in various ways. The following are the reasons why variable cost analysis is essential:
Pricing influences by Variable Costs
A corporation often seeks to price its items competitively to recuperate the cost of manufacturing the goods. A corporation will better understand its product inputs and what it needs to collect in revenue per unit to ensure profitability by undertaking variable cost analysis.
Necessary Component of Budgeting and Planning
A corporation may decide to quadruple its output next year to increase income. To do so, one must know that variable expenses will rise accordingly. Any strategic goals, including growth, contraction, or product expansion, will almost certainly result in adjustments to variable costs accordingly.
Break-Even Point Determination by Variable Costs
A company's break-even point is derived by dividing fixed expenses by the contribution margin, which is computed as revenue minus variable costs. A corporation may use variable cost analysis to determine how many things it needs to see to break even and how many units it needs to sell to make a certain amount of money.
Margin and Net Income Determination by Variable Costs
Gross margin, profit margin, and net income are frequently estimated using a mix of fixed and variable expenses. A corporation may quickly detect how scaling or lowering output affects profit projections by doing variable cost analysis.
Influence on the Expenditure Structure of a Business
Assume a corporation wishes to rent specific equipment. It has the option of paying $1,000 (fixed cost) or $0.05 for each item created. Because a company's spending structure influences its leverage, this selection will have a direct impact on its profitability and earning potential.
The idea of a relevant range is usually applied to fixed costs, while variable costs may also have an impact on a relevant range of their own. This may be true for the basic tangible items that may go into a good and the respective labour costs. Consider bulk wholesale pricing, which categorizes items' prices based on the quantity ordered.
Raw materials, for example, may cost $0.50 per pound for the first 1,000 pounds. On the other hand, orders of more than 1,000 pounds of raw material may be charged at the rate of $0.48. In either case, the variable cost is the raw materials fee.
Degree of Leverage
Variable and constant costs influence a company's operational leverage. In sum, fixed costs are riskier, produce more leverage, and leave the organization with more upside potential. Variable expenses, on the other hand, are less risky, create less leverage, and leave the organization with less upside potential.
Consider the following scenario of a corporation deciding whether to rent a piece of equipment for $1,000 (fixed) or $0.05 (per unit price):
If the corporation produces fewer than 20,000 units, it will lose money. On the other hand, anything over this has an infinite potential for value to the organization. As a result, leverage rewards the corporation for not picking variable expenses as long as it can create adequate output.
Margin of Contribution
Variable costs are a direct input in the computation of contribution margin, which is the number of revenues collected after deducting variable expenses from sale proceeds. Every dollar of the contribution margin goes straight toward covering fixed expenses; after all fixed costs are covered, every dollar of the contribution margin goes toward profit. As a result, variable expenses are necessary for businesses attempting to establish their break-even point. Furthermore, variable expenditures are required to calculate sales objectives for a specific profit target.
What is the difference between Fixed and Variable Costs?
Fixed costs are expenses that really don't change as a result of output. Whether a company earns through sales or not, it must pay its fixed costs that are unrelated to output. Fixed expenses usually include rent, staff pay, insurance, and office supplies. A corporation must pay rent for the area in which it operates regardless of how many things are created and sold. Rent will remain unchanged whether a company begins to grow or reduces output. Although fixed expenditures may vary over time, the fluctuation has nothing to do with productivity. As a result, fixed expenses are seen as long-term costs.
Variable costs can be affected by sales and production level fluctuations if elements such as sales commissions are incorporated into per-unit manufacturing costs. Meanwhile, even if output slows dramatically, fixed costs remain the same, while the variable costs vary accordingly. Semi-variable costs are those that fall between fixed and variable expenses. These are costs with both fixed and variable components. When a particular level of output or consumption is exceeded, costs become variable. Even when no output occurs, a fixed cost is typically incurred. Companies with a high proportion of variable expenses against fixed costs are perceived to be less volatile, as their earnings are more dependent on sales performance.
Average Variable Cost vs Variable Cost
Variable cost is commonly used to represent any single product's variable cost; average variable cost is frequently used to examine production over time and compare variable expenses to what has been generated. The average variable may be determined as follows:
Average Variable Cost = Total Variable Costs / Total Output
Because of price increases or pricing concessions, variable and average variable costs may sometimes differ. Consider the variable cost of a project that has been under development for several years. The hourly earnings of an employee are a variable expense; nevertheless, that person was promoted last year. The present variable cost will be greater than previously, whereas the average variable cost will be somewhere in the middle.
When average variable expenses are represented graphically, they frequently form a U-shape. As a result, by determining when to shut down production in the near term, a corporation may utilize average variable cost to examine the most efficient point of manufacture.
Variable Cost Example
A factory's expenses may be virtually constant rather than a variable over a single day's time frame. The corporation must pay for the facility, employee perks, and machinery regardless of whether anything is produced that day. The primary variable expenses include machine materials and any energy expenditures incurred during production.
Over six months, the manufacturer will be better able to adjust the number of workers to match the target production through overtime hours, layoffs, or employing new personnel. As a result, most of their work becomes variable-though not the managers' wages, which are paid monthly regardless of productivity.
All costs can become variable costs over five years. Suppose the company's long-run total cost exceeds its long-run total income. In that case, it can close down and sell off its buildings and equipment, or it can grow and increase the quantity of both if its long-run total revenue surpasses its long-run total cost, including variable expenses. It can alter its whole workforce, including management and line personnel.
Thus, expenses are classed as variable and fixed and are determined by the time horizon, which is most simply divided into the short and long run, but really encompasses a wide variety of time horizons.
How do variable costs affect growth and profitability?
Companies' variable costs will rise as they increase output to satisfy demand. If these expenses grow faster than the revenues earned by new units produced, it may be unwise to expand. In such a circumstance, a corporation must assess why it cannot attain economies of scale. Variable costs as a proportion of overall cost per unit fall as the manufacturing scale increase under economies of scale.
Is variable cost the same as marginal cost?
No. The marginal cost is the cost of producing one additional unit. The marginal cost will include fixed and variable expenses in the overall cost of manufacturing.
What is the Total Variable Cost Formula?
Because variable costs scale with output, each output unit should have the exact variable costs. As a result, total variable costs may be computed by multiplying total production by unit variable cost.
The Bottom Line
There are several forms of expenses in the manufacturing process. One of these is a variable cost that rises only if the number of items produced also rises. A fixed cost remains constant across a relevant range, but a variable cost fluctuates with each additional unit produced. While the variable cost structure protects a corporation if demand for its product falls, it restricts the current profit potential that the company could have earned with a more fixed-cost-focused strategy.