What is a Variable Cost?

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Definition:

A variable cost is an expense that changes with a company’s level of production — More output means higher costs, and less means lower costs.

🤔Understanding variable cost

Companies incur costs to produce goods and services. Some expenses scale in direct proportion to a company’s output. These are known as variable costs. For example, the more furniture a carpenter makes, the more wood he needs to buy to work with. Other costs, known as fixed costs, don’t change based on how much a company produces. The carpenter spends the same amount on renting his store whether he sells 100 pieces of furniture or just one.

Example

If a restaurant wants to sell food to customers, it needs to have raw materials such as meat, vegetables, and spices on hand. The more meals the restaurant sells, the more ingredients it needs to buy. The fewer dishes it sells, the less it spends on inputs. The ingredients are variable costs. On the other hand, fixed costs like rent, insurance, and the phone bill stay the same regardless of how many meals the restaurant sells.

Takeaway

Variable costs are like buying gas for your car…

When you drive your car, you have to fill up the tank. The more often you drive and the farther you go, the more gas your car consumes. If you don’t drive at all one month, you won’t have to pay for any gas. If you drive a lot the next month, you’ll have to buy a lot of gas. The amount you spend on fuel is directly related to how much you use your car. Similarly, how much a business spends on variable costs is directly connected to how many items it produces.

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What is a variable cost?

A variable cost is an expense that scales with a business’s level of production. When a company produces more, variable costs increase. When output decreases, so do variable costs.

Variable costs change with output because they are directly tied to production — Usually, these are the costs required to make goods. A company that makes clothing needs to buy fabric when it wants to produce more items. If the company decides to slow or stop production, it doesn’t need to buy as much fabric. Because the cost of the fabric changes with output, it is a variable cost.

Businesses have to pay some expenses regardless of how many products they make, or whether they produce anything at all. For example, a company that leases a factory needs to pay rent whether or not it uses the facility. These types of costs are fixed.

Some costs are semi-variable: They are not entirely fixed but don’t directly scale with a business’s output, either. An example of this is utilities, such as electricity or water. Typically, utility companies charge a flat fee to keep a business connected to the grid or water supply, plus an amount based on monthly usage. The charge has both a fixed and variable portion, making it a semi-variable cost.

Most businesses have both fixed and variable costs. Some companies have many fixed costs and few variable ones, while others have the opposite. Either situation has benefits and drawbacks for businesses.

What are some typical variable costs?

Variable costs are any expenses that scale in direct proportion to a company’s level of output. Some of the most common are:

  • Raw materials
  • Packaging costs
  • Wages (for employees producing the goods or providing the services)
  • Commissions
  • Shipping costs
  • Transaction fees

What is a fixed cost?

A fixed cost is an expense that does not change with a business’s level of production. These include things like:

The company has to pay these costs, and the amount is the same whether the firm produces one product or a thousand.

Fixed costs aren’t entirely set in stone, but they’re challenging to change. For example, a business could reduce its rent costs by letting a lease expire and moving to a cheaper location. Or it could take out a more affordable insurance policy when the current one is up for renewal. Calling something a fixed cost just means it’s usually difficult to change or can’t be changed quickly — It does not automatically vary along with production levels.

Why are variable costs important?

Understanding variable costs is essential for businesses because they play a significant role in profitability.

Knowing variable costs is key for setting prices. If the variable costs for creating and selling a product total $5, the sale price of that item must be higher than $5 for the product to turn a profit. Selling something for less than the sum of its variable costs will certainly result in a loss.

Variable costs also play into several important business calculations. One example is the cost of goods sold (the direct costs associated with creating a product or providing a service). Another is calculating the sales volume that a business needs to break even on sales of a product (make no profit or loss). The formula is:

If a company’s fixed costs are $1,000, it sells a product for $10, and the product has $5 in variable costs per unit, its break-even sales volume will be: $1,000 / ($10 - $5) = 200 units

Since variable costs affect profitability, calculating them can also help companies decide how many of each type of product to make. If product A sells for $10 and has variable costs of $8, the company only nets $2 from each sale. If product B sells for $5 but has variable costs of $1, the company nets $4 per sale, making product B more profitable despite its lower sales price. Therefore, the company may want to produce more units of product B.

Knowing how many of a company’s costs are variable and how many are fixed can also help with budgeting. If a company has high variable costs, it needs to be prepared for significantly increased costs when it boosts production. It might need to open a line of credit or build a cash reserve before expanding output. Businesses with more fixed costs don’t have to spend so much to increase production, but also can’t save as much money in lean times by reducing output.

How do you calculate variable costs?

To calculate the total variable cost for a product, you need to find the sum of each individual variable cost. This includes labor, utilities, raw materials, packaging, commissions, and transaction fees. To calculate a company’s total variable costs, use the following formula:

Total number of units produced x Variable cost per unit = Total variable cost

How to budget for variable costs

Because variable costs scale with a business’s output, a company must be ready to pay increased costs when it wants to grow production. While higher production may lead to more sales, this isn’t guaranteed. Plus any hike in sales revenue is likely to come after expenses are paid for. To cover higher variable costs, businesses need to budget for them before raising production.

The simplest way to budget for an increase in variable costs is to use the total variable cost formula.

For instance, if you plan on increasing production by 100 units next month and you know your variable costs are $10 per unit, then you will need an extra $1,000 to cover these costs (100 x $10). Similarly, if you plan on decreasing production by 100 units, you can predict that you’ll spend $1,000 less.

Of course, this method requires you to plan your output in advance. But what if your production volume is harder to predict? In this case, there are three common strategies companies adopt:

  1. Budget variable expenses based on an average, such as the average variable cost per month over the last 12 months.
  2. Budget based on the same time last year. If variable costs were $20,000 last December, you could choose to budget the same amount for this December. (This approach is usually better for seasonal businesses.)
  3. Take last month’s variable expense and add a buffer. If you think production will likely be similar, but you’re not sure, you can also budget for last month’s costs plus 10-20%. This gives you some wiggle room in case output suddenly increases.

Are variable costs good or bad?

Variable costs aren’t good or bad — Having high variable costs has both pros and cons.

Because variable costs directly scale with a business’s production, having high variable expenses can make a company better able to react to changes in the market. If customer demand drops, the company can reduce its output to save money, or vice versa. A business with higher fixed expenses would struggle to save money in a market downturn.

The downside is that businesses with high variable costs benefit less from increasing production compared to a company with high fixed costs. That’s because higher fixed costs let businesses take more advantage of economies of scale.

Economies of scale refer to the fact that fixed costs don’t change with the number of units produced. As a firm makes more units of a product, the fixed costs are divided across more items, making the fixed cost per unit lower. This example shows the effect that fixed and variable costs have on total costs when output changes.

HeaderCompany ACompany B
Fixed Costs$500$1,000
Variable Cost per Unit$2$1

If each company sells 500 units, their respective costs add up to $1,500, or $3 per unit. If they increase production to 1,000 units, Company A’s costs become $2,500 while Company B’s costs are $2,000. Company A’s total cost per unit is $2.50, while company B’s is $2.

At 500 units produced, Company A’s fixed cost per unit is $1, while Company B’s fixed cost per unit is $2. That means that both companies’ total cost per unit is $3.

At 1,000 units produced, Company A’s fixed cost per unit is $0.50, while company B’s fixed cost per unit is $1. That makes company A’s total cost per unit $2.50 and company B’s total cost per unit $2. Company B’s higher fixed costs bring it greater benefits from economies of scale, driving down its total cost per unit more quickly as the number of units produced rises.

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