What Is a Variable Cost?

Business expenses broadly fall into two categories: variable or fixed. Fixed costs remain constant regardless of changes in the level of production. Variable costs fluctuate with the lܫevel of production. The cost of raw materials would be variable because it rises or falls when a company increases or decreases production.

How Variable Costs Work

The total expenses incurred by any business consist of variable and fixed co♔sts.

Variable costs are dependent on the level of production output or sales. The variable cost of production is a constant amount per unit produced. As the volume of production and output increases, variable co꧑sts will also increase.

Examples of variable costs are sales 澳洲幸运5开奖号码历史查询:commissions, direct🍃 labor costs, cost of raw materials used in production, and utility costs.

Formula and Calculation of Variable Costs

The total variable cost is the quantity of output multiplied by the vari⭕able cost per unit of output:

Total Variable Cost  =  Total Quantity of Output x Variable Cost Per Unit of Output

The variable cost per unit will vary across profits. In general, it can often be specifically calculated as the sum of the types of variable costs. Vari🌃able costs may need to be allocated across goods if they are incurred in batches (i.e. 100 pounds of raw materials are purchased to manufacture 10,000 finished goods).

Types of Variable Costs

Along the manufacturing process, there are specific expenses that a🦹re usually variable costs. For the examples of these variable costs below, consider the manufacturing and distribution processes for an athletꦕic apparel producer.

Raw materials

Raw materials are the goods that a busines🙈s purchases to create a final product. If the athletic brand buys the shoes rather than manufacturing them, it won't incur the cost of leather, mesh, canvas, or other raw materials.

In general, a company should spend roughly the same amount on raw materials for every unit produced assuming no major differences🐓 in manufacturing one unit versus another.

Direct labor

Direct labor costs will v🐟ary depending on the units 🅠produced. The more units produced, the more direct labor costs.

Some labor costs will be incurred even if no units are produced. A salaried accountant or company lawyer will be paid whether the company's output is 100,000 units or 0 units.

For others who are paid an hourly rate, more labor hours re𝕴sult in higher paychecks🌳.

Commissions

澳洲幸运5开奖号码历史查询:Commissions are a percentage of a sale's proceeds that are awarded to a salesperson as a💜dditional compensꦡation. If no sales are executed, there is no commission expense.

Because commissions rise and fall in line with whatever underlying target the salesperson must hit, the expens🐈e ♔varies with changes in production.

Utilities

When a manufacturer line ramps up production, it consumes more energy. When production is shut down, minimal utili꧋ties are consumed.

In this example, ut𓆉ilities usually vary with production. As a company strives to produce more output, it is likely to require additional power, resulting in increased variable utilityꦗ costs.

Shipping/freight

The total cost of shipping finished products varies depending on the number o🐻f units shipped.

There may be fixed cost components, such as the cost of an in-house email 澳洲幸运5开奖号码历史查询:distribution network, but most shipping costs are variable.

Importance of Variable Cost Analysis

Variable costing data is used to analyze expenses, pricing, and profitability. Variable cost analysis is importan🌺t for the following reasons:

• Variable costs help determine pricing. A company strives to 澳洲幸运5开奖号码历史查询:competitively price its goods to recover the cost of manufacturing them. By performing variable cost analysis, the company can establish the right price for its products to turn a profit.
• Variable costs are an integral part of budgeting and planning. A company may plan to double its output next year to scale revenue. To do so, it must calculate the impact on its expenses. Any strategic plans relating to growth, contraction, or expansion to new products incur changes to variable costs
• Variable costs determine the break-even point. A company's 澳洲幸运5开奖号码历史查询:break-even point is calculated as fixed costs divided by contribution margin, and contribution margin is calculated as revenue minus variable costs. A company can leverage variable cost analysis to calculate exactly how many items it needs to sell to break even and how many units it needs to sell to make a 澳洲幸运5开奖号码历史查询:specific amount of money.
• Variable costs determine margins and net income. Gross margin, profit margin, and net income calculations are calculated with a combination of fixed and variable costs. By performing variable cost analysis, a company can easily identify how scaling or decreasing output will impact profit calculations.
• Variable costs impact a company's expense structure. Imagine a company that wants to rent a piece of equipment. It can choose between paying $1,000 (fixed cost) or $0.05 for every item manufactured. This decision will have a direct impact on the profitability and earning potential of the company since its expense structure determines its leverage.

Variable Cost vs. Average Variable Cost

Variable cost and average vari🦩able cost are not the same. While variable cost measures the cost of producing a single product, average variable cost analyzes production over tim🅰e and compares variable costs to what has been produced. The average variable can be calculated as:

Average Variable Cost = Total Variable Costs / Total Output

Variable cost and average variable cost may not always be equal due to price increases or discounts. Consider the variable cost of a project that has been worked on for years. The salary of an employee assigned to thღe project is a variable cost and, in this case, the employee was promoted last year. The current variable cost will be higher than before; the average variable cost will remain somewhere in between.

Average variable cost is often 👍U-sha🌊ped when plotted graphically. Therefore, a company can use average variable costing to analyze the most efficient point of manufacturing by calculating when to shut down production in the short term or even when to shut down a plant.

Variable Costs vs. Fixed Costs

Fixed costs remain the same regardless of production output. Examples of fixed costs are rent, salaries, 澳洲幸运5开奖号码历史查询:insurance, and office supplies.

A company must pay these expenses irrespective of the volume of products it manufactures and sells. Whether production increases or decreꦫases, rent will stay the same.

Even fixed costs can change over time, but the change will not be related to production. As such, fixed costs are viewed as lo𝓰ng-term expenses.

There is also a category of costs that falls between fixed and variable costs, known as 澳洲幸运5开奖号码历史查询:semi-variable costs (sometimes called semi-fixed costs or mixed costs). These are costs composed of a 澳洲幸运5开奖号码𓆏历史查询:m⛄ixture of fixed and variable components. Costs are fixed for a set level of production or consumption and become variable after this production level is exceeded. If no production occurs, a fixed cos💦t is often still incurred.

Special Considerations

Several factors play into an evaluation of a company's expenses, fixed or variable. These include relevant range, degree of leverage, and contribution margin.

Relevant range

The concept of relevant range primarily relates to fixed costs. This may hold true for♑ tangible products associated with the production of goods as well as labor costs, particularly overtime costs.

Consider wholesale bulk pricing that prices goods in tiers based on the quantity 🦂ordered. Raw materials may cost $0.50 per pound for the first 1,000 pounds, while orders of greater than 1,000 pounds are charged $0.48. In either situation, the variable cost is the charge for the raw materials (either $0.50 per pound or $0.48📖 per pound).

Degree of leverage

Variable and fixed costs play into the degree of operating leverage a company has.

Iꦺn short, fixed costs are riskier, they generate a greater degree of leverage, and they leave the company with greater upside potential. Variable costs are safer, generate less leverage, and leave the company with a smaller upside potential.

Consider the example above with a companyᩚᩚᩚᩚᩚᩚ⁤⁤⁤⁤ᩚ⁤⁤⁤⁤ᩚ⁤⁤⁤⁤ᩚ𒀱ᩚᩚᩚ choosing between renting a piece of equipment for $1,000 or $0.05 per unit produced:

• If the company manufactures just one unit of output, it is $999.95 more favorable to opt for the per-unit price.
• If the company manufactures 20,000 units of output, the two options break even.
• If the company manufactures 1,000,000 units of output, it is $49,000 more favorable to opt for the fixed price.

The compaꦗny faces the risk of loss if it produces less than 20,000 units. However, anything above this has limitless potential for yielding benefits for the company.

Therefore, leverage rewards the company for not choosing variable costs, as long as the company can 💙produce enough output.

Contribution margin

Variable costs are a direct input in the calculation of 澳洲幸运5开奖号码历史查询:contribution margin, the amount of proceeds a company colle꧟cts after using sale proceeds to cover variable costs.

Every dollar of contribution margin goes directly to paying for fixed costs; once all fixed costs have been paid fo✅r, ev🔥ery dollar of contribution margin contributes to profit.

For this reason, variable costs ♌are a required item for companies trying to determine their break-even point. In addition, variable costs are necessary to determine sale targetꦦs for a specific profit target.

Example of a Variable Cost

Let’s assume that it costs a bakery $15 to make a cake—$5 for raw materials such as su♛gar, milk, and flour, and $10 for the direct labor involved in making one cake. The table below shows how the variable costs change as the number of cakes baked varies.

As the production output of cakes increases, the bakery’s variable costs also increase. When the bakery does not 💞bake any cake, its variable costs drop to z🍒ero.

Fixed costs a✃nd variable costs comprise the total cost. Total cost is a determinant of a company’s profits, which is calculated as:

$\begin{aligned} &\text{Profits} = Sales - Total~Costs\\ \end{aligned}$​Profits=Sales−Total Costs​

A company can increase its profits by decreasing its total costs. Since fixed costs are more challenging to bring down (for example, reducing rent may entail moving to a cheaper location), most businesses seek to reduce their variable costs. Decreasing costs usually means decr𒅌easing variable costs.

If the bakery sells each cake for $35, its 澳洲幸运5开奖号码历史查询:gross profit per cake will be $35 - $15 = $20. To calculate the net profit, the fixed costs have to be subtracted from the gross profit. Assuming the bakery incurs monthly fixed costs of $900, which includes utilities, rent, and insur😼ance, its monthly profit will look like this:

A business incurs a loss when fixed costs are higher than gross profits. In the bakery’s case, it has gross profits of $700 - $300 = $400 when i💖t sells only 20 cakes a month. Since its fixed cost of $900 is higher than $400🍎, it would lose $500 in sales.

The break-even point occurs when fixed costs equal the 澳洲幸运5开奖号码历史查询:gross margin, resulting in no profits or losses. In this case, 💃when the bakery sells 45 cakes for a total variable cost of $675, it bre🐼aks even.

A company that seeks to increase its profit by decreasing variable costs may need to cut down on fluctuating costs for raw materials, direct labor, and advertising. However, the co♔st cut should not affect👍 product or service quality as this would damage sales.

By reducing its variable costs, a business increases its gross profit margin or 澳洲幸运5开奖号码历史查询:contribution margin.

The contribution margin allows management to determi⛄ne how much revenue and profit can be earned from each unit of product sold. The contribution margin is calculated as:

$\begin{aligned} &\text{Contribution~Margin} = \dfrac{Gross~Profit}{Sales}=\dfrac{ (Sales-VC)}{Sales}\\&\textbf{where:}\\&VC = \text{Variable Costs}\\ \end{aligned}$​Contribution Margin=SalesGross Profit​=Sales(Sales−VC)​where:VC=Variable Costs​

Tꦗhe contribution margin for the bakery is ($35 - $15) / $35 = 0.5714, or 57.14%. If the bakery reduces its variable costs to $10, its contribution margin will increase to ($35 - $10) / $35 = 71.43%. Profits increase when the contribution margin increases. If the bakery reduces its variable cost by $5, 🔯it would earn $0.71 for every dollar in sales.

The Bottom Line

In a maܫnufacturing process, there are different types of costs. One type of cost is variable, increasing only if the quantity of output also increases. While a fixed cost remains the same over a relevant rang🔴e, a variable cost usually changes with every incremental unit produced.

Though this cost ᩚᩚᩚᩚᩚᩚ⁤⁤⁤⁤ᩚ⁤⁤⁤⁤ᩚ⁤⁤⁤⁤ᩚ𒀱ᩚᩚᩚstructure protects a company in the event the demand for their goods decreases, it limits the upside profit potential the company could have received with a more fixed-cost-focused strategy.