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Variable costs are expenses that rise and fall with production and sales. For industries like mass-produced manufacturing, these costs may be predictable, as goods may consistently require the same labor and resources. But for businesses with volatile demand, such as restaurants or producers of custom goods, average variable costs may fluctuate significantly from one period to the next. Regardless of industry, understanding and managing variable costs may be crucial for helping to control expenses and remaining profitable.
Why? Businesses use variable cost data to help set accurate prices, budget effectively, forecast profits, and more. Read on to learn what variable costs are and how to calculate them using four different formulas.
What Is a Variable Cost?
A variable cost is any business expense that’s directly tied to a company’s production or sales volume. When output increases, variable costs rise — when production slows, they fall. Tracking these expenses could be important for cost management and understanding profit margins, as they may be one factor considered in calculating a product’s break-even point.
Fixed vs. Variable Costs
Variable costs fluctuate with production volume. Common examples may include raw materials, packaging, hourly labor, shipping, and sales commissions. Fixed costs remain constant regardless of output and may stay the same from one financial period to the next. Common fixed expenses include rent, insurance, loan payments, and salaries.
The simplest way to identify a variable cost from a fixed cost is by asking this question: “If we didn’t make or sell any products, would I still have to pay this?” If the answer is no, it may be a variable cost. If yes, it may be fixed.
Consider a pen manufacturer: Fixed costs would include machinery, administrative salaries, and factory rent — all of which should stay steady month over month even if the manufacturer scales up production within that facility. However, variable costs like sub-contracted labor and materials such as ink, plastic, and metal may increase proportionally.
Understanding fixed vs. variable costs might help businesses balance budgets, forecast expenses, and evaluate how changes in production volume could affect overall profitability.
Examples of Variable Costs
The types of variable costs a business incurs may depend on its industry and operations. Variable costs for a marketing agency may include professional and licensing fees, while a manufacturer's variable costs may be more likely to center on raw materials. Some businesses may have additional variable costs to consider: A food service company, for instance, might pay to dispose of unsold inventory.
Businesses may track total variable costs as a single figure or take a more granular approach by separating them into three categories:
- Direct costs: The cost of goods tied to producing and purchasing inventory, including vendor rates for raw materials and hourly wages.
- Shipping costs: Expenses for getting goods to customers, such as fuel, delivery fees, and border handling.
- Marketing costs: Spending that varies based on audience, advertising type, and market rates.
How to Calculate Variable Costs
There’s no single formula for how to find variable costs. Businesses may choose from several approaches, ranging from simply adding costs together to multiplying per-unit costs by total output. Here are four variable cost formulas and what they might reveal about pricing, budgeting, and profitability.
1. Total Variable Cost Formula
To calculate total variable costs, you may multiply the variable cost per unit by the total number of units produced.
Total Variable Cost = Average Variable Cost Per Unit × Total Number of Units Produced
For example, a Christmas tree manufacturer has variable costs including raw materials (lights, stands), packaging (boxes, packing materials), labor (seasonal workers), and distribution (shipping and freight). If the company spends $45 per tree on variable costs and produces 100,000 trees, the total variable cost is $4.5 million ($45 × 100,000 trees).
Understanding this formula may help businesses forecast future costs and model different scenarios like “What if our supplier increases prices by 5%?” or “How would a 20% shipping cost increase affect gross profit margins?” Running these scenarios with hard numbers could help financial teams develop strategies to protect profitability, such as switching to more affordable vendors or delivery services.
2. Average Variable Cost Formula
The average variable cost (AVC) measures variable cost per unit produced or sold.
Average Variable Cost Per Unit = Total Variable Cost / Total Number of Units Produced
If the hypothetical Christmas tree manufacturer’s total variable costs remained $4.5 million the following year but production dropped to 80,000 trees, AVC would jump to $56.25 per unit ($4.5 million / 80,000 trees) — an $11.25 increase per tree from the previous year.
Businesses use this metric to help determine whether prices cover per-unit variable costs and how much is left over for other purposes. If the Christmas tree company charged $55 per tree last year and kept prices steady, their per-tree margin would drop from $10 to a $1.25 loss with every sale — an unsustainable model even before accounting for fixed costs like rent or administrative expenses. Remember, profit is what remains after covering both variable and fixed costs, so pricing just above AVC may not be enough.
3. Semi-Variable Cost Formula
Semi-variable or mixed costs have both fixed and variable components. These may be common for services with base fees and additional charges, such as a utility bill with a fixed delivery charge alongside variable usage rates.
Semi-Variable Cost = Fixed Cost of Specific Expense + Variable Cost of Specific Expense
Consider a bakery contracted to buy a weekly minimum of 500 pounds of flour for $1,000. Each pound of flour creates one loaf, and any flour beyond the 500 minimum costs an extra $1 per pound. At 500 loaves or lower, the cost is simply the $1,000 fixed amount. But if production increases to 1,000 loaves, the bakery pays $1,000 plus $500 for 500 additional pounds for a total semi-variable cost of $1,500.
Understanding semi-variable costs may help businesses calculate break-even points, determine cost-effective order sizes, and set profitable prices. In this example, the increased order size drops the per-loaf cost from $2.00 ($1,000/500 loaves) to $1.50 ($1,500/1,000 loaves). Assuming sales keep pace and other costs remain stable, this can potentially increase margins without raising prices.
4. The Variable Cost Ratio
The variable cost ratio expresses variable costs as a percentage of net sales. A lower ratio may mean more leftover revenue for fixed costs and profit after the business pays its variable costs.
Variable Cost Ratio = (Total Variable Costs / Net Sales) × 100
Say a furniture company sells handmade chairs for $500 each with $75 per chair going towards variable costs like hourly labor, raw materials, and shipping. The variable cost ratio is 15% [($75/$500) × 100], so 15% of revenue covers variable costs and 85% remains for fixed costs and profit.
Tracking this ratio may help identify where cost cutting might influence profitability most. If supply chain pressures increase the furniture company’s shipping rates, the ratio rises and margins shrink. Monitoring changes over time may allow businesses to catch rising costs early and respond accordingly, whether by negotiating with vendors, finding efficiencies, or raising prices.
Break-Even Analysis: Definition and 4 Strategic Benefits
Businesses spend money to produce goods and provide services, but variable costs could be one area where they can have real control. Understanding these costs may be essential to calculating the break-even point — the sales volume at which revenue equals total costs. The break-even point may be useful when making informed pricing decisions and developing realistic business plans.
To learn more about break-even analysis and its strategic benefits, read Break-Even Analysis: Definition and 4 Strategic Benefits.
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