Variable Cost

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What is a 'Variable Cost'

A variable cost is a corporate expense that changes in proportion with production output. Variable costs increase or decrease depending on a company's production volume; they rise as production increases and fall as production decreases.

BREAKING DOWN 'Variable Cost'

The total expenses incurred by any business consist of fixed costs and variable costs. Fixed costs are expenses that remain the same regardless of production output. Whether a firm makes sales or not, it must pay its fixed costs, as these costs are independent of output. Examples of fixed costs are rent, employee salaries, insurance, and office supplies. A company must still pay its rent for the space it occupies to run its business operations irrespective of the volume of product manufactured and sold. Although, fixed costs can change over a period of time, the change will not be related to production.

Variable costs, on the other hand, are dependent on production output. The variable cost of production is a constant amount per unit produced. As volume of production and output increases, variable costs will also increase. Conversely, when fewer products are produced, the variable costs associated with production will consequently decrease. Examples of variable costs are sales commissions, direct labor costs, cost of raw materials used in production, and utility costs. The formula for variable cost is given as:

Total variable cost = Quantity of output x Variable cost per unit of output.

Variable Cost Example

For example, let’s assume that it costs a bakery $15.00 to bake a cake - $5.00 for raw materials such as sugar, milk, and flour, and $10.00 for the direct labor involved in baking 1 cake. The table below shows how the variable costs change as the number of cakes baked vary.

 

1 cake

2 cakes

7 cakes

10 cakes

0 cakes

Cost of sugar, flour, butter, and milk

$5.00

$10.00

$35.00

$50.00

$0.00

Direct labor

$10.00

$20.00

$70.00

$100.00

$0.00

Total variable cost

$15.00

$30.00

$105.00

$150.00

$0.00

As the production output of cakes increases, the bakery’s variable costs also increase. When the bakery does not bake any cake, its variable cost drops to zero.

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

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 the company moving to a cheaper location), most businesses seek to reduce their variable costs. Therefore, decreasing costs usually means decreasing variable costs. If the bakery sells each cake for $35.00, its 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, rents, and insurance, and its monthly profit will be:

Number sold

Total Variable Cost

Total Fixed Cost

Total Cost

Sales

Profit

20 cakes

$300

 

 

$900

 

$1,200

$700

$(500)

45 cakes

$675

$1,575

$1,575

$0

50 cakes

$750

$1,650

$1,750

$100

100 cakes

$1,500

$2,400

$3,500

$1,100

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 it 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 equals the gross margin, resulting in no profits or loss. In this case, when the bakery sells 45 cakes for total variable costs of $675, it breaks 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 cost cut should not affect product or service quality as this would have an adverse effect on sales. By reducing its variable costs, a business increases its gross profit margin or contribution margin.

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

Contribution Margin = Gross Profit / Sales = (Sales – Variable Costs) / Sales

The 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 one dollar in sales.