Variable costs are expenses that rise and fall with production and sales. In industries like manufacturing, these costs may be fairly predictable, as mass-produced goods consistently require the same labor and resources. Conversely, businesses such as restaurants or those offering customizable products can face significant cost fluctuations. Understanding and managing these variations is crucial, regardless of the industry or business size.
Why? This data can be used to set accurate prices, budget effectively, forecast profits, and more. Read on to learn the different types of variable costs, and why tracking them is so important to your business.
What Is a Variable Cost?
A variable cost is any business expense that is directly correlated to your company’s production or sales. If sales or production increase, variable costs increase as well. If sales or production fall, then those costs can also fall. The easiest way to determine if a cost is variable, therefore, is to work out if the cost changes alongside output. Some examples of variable costs include raw materials, hourly labor, shipping costs, and sales commissions.
Variable Costs vs. Fixed Costs
Fixed costs are those that a business should cover regardless of how many products are made and sold. These costs are often the same from one financial period to the next, and include expenses like insurance, rent, or loan payments.
A pen maker’s fixed costs, for example, would include the cost of the machinery to make the pens, administrative salaries, and factory rental costs – all of which remain steady regardless of production levels. In contrast, if the pen manufacturer scales up production, its variable costs – such as the amount spent on sub-contracted labor and raw materials like ink, plastic, and metal – would increase proportionally.
Examples of Variable Costs
The types of variable costs incurred by businesses can vary depending on the nature and industry of the business. For instance, variable costs for a professional services firm such as a marketing agency, may include professional and licensing fees, as opposed to a manufacturer’s raw material costs. Some industries may have additional variable costs to consider; a food service company for example may need to pay to dispose of unsold food.
Companies can choose the level of detail they focus on when tracking variable costs. A business might look at its total variable costs at a high level, or it could take a more granular approach by separating variable costs into three categories:
- Direct costs: The direct cost of goods tracks the physical cost of producing and buying inventory. Direct costs depend on vendor rates and hourly employee wages.
- Shipping costs: are spends associated with getting goods to customers. Shipping costs can include fuel rates, delivery costs, and border handling fees.
- Marketing costs: Marketing spend can vary depending on the intended audience, type of advertising, and market rates.
By understanding variable cost formula, companies can create more accurate forecasts for future costs. Financial teams can run “what-if” scenarios, like “how would our total costs be impacted by a 5% supplier price increase or a 20% increase in shipping costs?”
How to Calculate Variable Costs
There’s no single formula for calculating variable costs, and a business can choose a formula tailored to its needs. Here are four variable cost formulas and what they can show business leaders and analysts.
1. Total Variable Cost Formula
To calculate total variable costs, a company multiplies the variable costs attributed to producing one unit of a particular product by the total number of units produced in a particular period. This variable cost formula is:
Total Variable Cost = Average Variable Cost Per Unit x Total Number of Units Produced
For example, if a company manufactures Christmas trees, the variable costs might include:
- Raw materials, such as lights and stands.
- Packaging, such as boxes, packing materials, and string.
- Labor, such as seasonal workers who make, package, and sell the trees.
- Distribution, such as shipping and installation costs.
Let’s say the company spends $45 in variable costs, on average, to produce a single Christmas tree. These variable costs include materials, packaging, labor, and distribution. If the company produced 100,000 Christmas trees in 2022, the variable cost formula shows that the total variable cost for the year was $4.5 million (100,000 trees x $45 per tree).
By understanding this variable cost formula, companies can create more accurate forecasts for future costs. Financial teams can run “what-if” scenarios, like “how would our total costs be impacted by a 5% supplier price increase or a 20% increase in shipping costs?” Accounting software or spreadsheets can be used to quickly calculate variable costs and see how such scenarios can affect gross profit margins. Decision makers can then develop strategies to protect or expand margins if variable costs change.
For example, if a 5% increase in supplier prices will have a major impact on the Christmas tree manufacturer’s profit margins, the company can plan accordingly by finding less expensive vendors for lights, stands, and packaging materials, or using a more affordable delivery service.
2. Average Variable Cost Formula
The average variable cost (AVC) is a way of measuring the average variable cost per unit sold. The formula for calculating average variable cost is:
Average Variable Cost Per Unit = Total Variable Cost / Total Number of Units Produced
Revisiting the Christmas tree example, let’s say the company’s total variable cost for 2023 was also $4.5 million, but the company produced only 80,000 trees that year. This means average variable cost jumped to $56.25 per unit, an $11.25 increase from 2022 ($4.5 million / 80,000 trees).
Businesses can use this metric to understand if their profit is exceeding their variable costs. If the price charged to the customer is above the AVC, then the business is covering its variable costs per unit and then some. If the price is set below the AVC, then the company’s sales are no longer covering variable costs, on average, and goods are being sold at a loss. However, it’s important to remember that for a business to be profitable, its revenue should cover both variable and fixed costs. Therefore, pricing just above the AVC might not be enough to turn an overall profit.
3. Semi-Variable Cost Formula
Semi-variable costs, also known as “mixed costs,” have a fixed component and a variable component. These costs are common for services with a set fee or minimum order threshold, with an additional cost element depending on how that item is used. A common semi-variable business cost is a gas and electricity bill that includes a fixed delivery charge, regardless of how much gas or electricity is used, plus a variable usage rate.
The formula to calculate the semi-variable cost of a specific expense is:
Semi-Variable Cost = Fixed Cost of Specific Expense + Variable Cost of Specific Expense
For example, consider a bakery with a contract to buy a minimum of 500 pounds of bread flour each week, at a cost of $1,000. The 500 pound standing order can be used to make 500 loaves, but if the bakery needs more flour, each extra pound will cost an additional $1. This means the bakery has a fixed weekly cost of $1,000 to get its 500 pounds of flour, and the cost remains the same whether the bakery makes no bread or 500 loaves. In such a case, there’s no flour-related semi-variable cost to account for.
However, if the bakery increases production to make 1,000 loaves, they will need more flour. This also means they’ll need to pay an additional variable cost of $500 for the extra 500 pounds of flour (500 pounds at 1$/lb). Add this $500 variable cost to the fixed $1,000 and the total semi-variable cost for 1,000 loaves would be $1,500.
Understanding semi-variable costs like these can help businesses calculate break-even points, determine cost-effective order sizes, and set prices to maximize profits. In the case of the bakery, the semi-variable cost for the smaller standing order is $2.00 per loaf ($1,000/500 loaves) but drops to $1.50 for the larger order ($1,500/1,000 loaves). As the cost-per-loaf decreases, the baker has the potential to increase their margins without raising prices, assuming sales keep pace and labor costs (as well as fixed costs) remain constant.
4. The Variable Cost Ratio
The variable cost ratio expresses a company’s variable costs as a percentage of net sales. The lower the ratio, the more likely a company is to make a profit from sales, as there will be a higher percentage of revenue left over to apply towards fixed costs.
The formula for variable cost ratio is:
Variable Cost Ratio = (Total Variable Costs / Net Sales) x 100
For example, a furniture company charges customers $500 for its handmade chairs. The company’s total variable costs, including hourly labor, raw materials, and shipping, are $75 per item. In this case, the variable cost ratio is 15%, or ($75/$500) x 100. This means that 15% of the chair revenue is consumed by variable costs, leaving 85% for other purposes.
Businesses can use variable cost ratios to identify opportunities where reducing costs can make the biggest impact on overall profitability and cost-efficiency. To continue the furniture seller example, say global supply chain pressures cause shipping rates to increase. This would cause a direct rise in the variable cost ratio, reducing the profits from each sale. By tracking changes in this rate over time, businesses can catch areas where costs are rising and address them to maintain profitability, such as, in this example, increasing customer shipping rates to cover the higher expense.
The Bottom Line
Businesses should spend money to keep producing goods and providing services, but that doesn’t mean that they have no control over where and how that money gets spent. This is especially true for variable costs, which are directly tied to a business’s output. By carefully calculating and analyzing these variable costs, businesses can assess the profitability of their goods and services, ultimately leading to better informed pricing strategies, more efficient business plans, and maximum profits from each and every sale.
A version of this article was originally published September 9, 2022.
Photo: Getty Images
