What Is the Variable Cost Ratio?

The variable cost ratio is used in cost accounting to express a company's variable production costs as a percentage of net sales, calculated as variable costs divided by net revenues (total sales, minus returns, allowances, and discounts).

The ratio compares costs that vary with levels of production to the amount of revenues generated by that production. It excludes fixed costs that remain constant regardless of production levels, such as a building lease.

The Formula for the Variable Cost Ratio Is

Variable Cost Ratio=Variable CostsNet Sales\begin{aligned} &\text{Variable Cost Ratio} = \frac{ \text{Variable Costs} }{ \text {Net Sales} } \\ \end{aligned}Variable Cost Ratio=Net SalesVariable Costs

What Does the Variable Cost Ratio Tell You?

The variable cost ratio, which can alternatively be calculated as 1 - contribution margin, is one factor in determining profitability. It indicates whether a company is achieving, or maintaining, the desirable balance where revenues are rising faster than expenses.

The variable cost ratio quantifies the relationship between a company's sales and the specific costs of production associated with those revenues. It is a useful evaluation metric for a company's management in determining necessary break-even or minimum profit margins, making profit projections and in identifying the optimal sales price for its products.

If a company has high variable costs in relation to net sales, it likely doesn't have many fixed costs to cover each month, and can stay profitable with a relatively low amount of sales. Conversely, companies with high fixed costs will have a lower ratio result, meaning they have to earn a good amount of revenue just to cover fixed costs and stay in business, before seeing any profits from sales.

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 percent, 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 percent.

Key Takeaways

  • The variable cost ratio shows the total variable expenses a firm incurs in percent terms, as a proportion of its net sales.
  • A high ratio result shows that a company can make profits on relatively low sales since it doesn't have many fixed costs to cover.
  • A low ratio reveals that a company has high fixed costs to cover and must hit a high break-even sales level before it makes any profits.

The Difference Between Variable Costs and Fixed Costs

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 are understood.

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.