What is the 'Variable Cost Ratio'
The variable cost ratio is an expression of a company's variable production costs as a percentage of sales, calculated as variable costs divided by total revenues. It compares costs that change with levels of production to the amount of revenues generated by production. This contrasts with fixed costs that remain constant regardless of production levels.
BREAKING DOWN 'Variable Cost Ratio'Consideration of the variable cost ratio, which can alternately be calculated as 1 - contribution margin ratio, is one factor in determining profitability, since it indicates if a company is achieving, or maintaining, the desirable balance where revenues are rising faster than expenses.
The variable cost ratio quantifies the relationship between revenues and the specific costs of production associated with the revenues. It is a useful evaluation metric for a company's management in determining necessary minimum profit margins, making profit projections and in identifying the optimal sales price for a product as part of price setting. The variable cost calculation can be done on a per-unit basis, such as a $10 variable cost for one unit with a sales price of $100 giving a variable cost ratio of 0.1 or 10%, or by using totals over a given time period, such as total monthly variable costs of $1,000 with total monthly revenues of $10,000 also rendering a variable cost ratio of 0.1 or 10%.
Variable Costs, Fixed Expenses, Revenues, Contribution Margin and Profits
The variable cost ratio and its usefulness are easily understood once the basic concepts of variable costs, fixed expenses, and their relationship to revenues and general profitability is grasped.
The two expenses that must be known to calculate total production costs and determine profit margin are variable costs and fixed costs, also referred to as fixed expenses.
Variable costs are variable in the sense they fluctuate in relation to the level of production, or output. Examples of variable costs include the costs of raw material and packaging. These costs increase as production increases and decline when production declines. It should also be noted that increases or decreases in variable costs occur without any direct intervention or action on the part of management. Variable costs commonly increase at a fairly constant rate in proportion to increases in expenditures on raw materials and/or labor.
Fixed expenses are general overhead or operational costs that are "fixed" in the sense they remain relatively unchanged regardless of levels of production. Examples of fixed expenses include facility rental or mortgage costs and executive salaries. Fixed expenses only change significantly as a result of decisions and actions by management.
The contribution margin is the difference, expressed as a percentage, between total sales revenue and total variable costs. Contribution margin refers to the fact this figure delineates what amount of revenue is left over to "contribute" toward fixed costs and potential profit. The contribution margin ratio is always the inverse of the variable cost ratio.