Variable Cost: What It Is and How to Calculate It

Variable Cost Definition

Investopedia / Sydney Saporito

What Is a Variable Cost?

A variable cost is a corporate expense that changes in proportion to how much a company produces or sells. Variable costs increase or decrease depending on a company's production or sales volume—they rise as production increases and fall as production decreases.

Examples of variable costs include a manufacturing company's costs of raw materials and packaging—or a retail company's credit card transaction fees or shipping expenses, which rise or fall with sales. A variable cost can be contrasted with a fixed cost.

Key Takeaways

  • A variable cost is an expense that changes in proportion to production output or sales.
  • When production or sales increase, variable costs increase; when production or sales decrease, variable costs decrease.
  • Variable costs stand in contrast to fixed costs, which do not change in proportion to production or sales volume.
  • Variable costs are a central part in determining a product's contribution margin, the metric used to determine a company's break-even or target profit level.
  • Examples of variable costs include raw materials, labor, utilities, commission, or distribution costs.
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Variable Costs

Understanding Variable Costs

The total expenses incurred by any business consist of variable and fixed costs. Variable costs are dependent on 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 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.

Variable costs are usually viewed as short-term costs as they can be adjusted quickly. For example, if a company is having cashflow issues, they may immediately decide to alter production to not incur these costs.


Formula and Calculation of Variable Costs

The total variable cost is simply the quantity of output multiplied by the variable 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 discussed below. Variable 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 items that are usually variable costs. For the examples of these variable costs below, consider the manufacturing and distribution processes for a major athletic apparel producer.

Raw Materials

Raw materials are the direct goods purchased that are eventually turned into a final product. If the athletic brand doesn't make the shoes, it won't incur the cost of leather, synthetic 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

The athletic company also won't incur some types labor if it doesn't produce more output. Some positions may be salaried; whether output is 100,000 units or 0 units, certain employees will receive the same amount of compensation. For others that are tied to an hourly job, putting in direct labor hours results in a higher paycheck.

Commissions

Commissions are often a percentage of a sales proceeds that is awarded to a company as additional compensation. If no sales are executed, there is no commission expense. Because commissions rise and fall in line with whatever underlying qualification the salesperson must hit, the expense varies (i.e. is variable) with different activity levels.

Utilities

When the manufacturing line turns on equipment and ramps up product, it begins to consume energy. When its time to wrap up product and shut everything down, utilities are often no longer consumed. In this example, utilities usually vary with production. As a company strives to produce more output, it is likely this additional effort will require additional power or energy, resulting in increased variable utility costs.

Shipping/Freight

The cost to package or ship a product will only occur if certain activity is performed. Therefore, the cost of shipping a finished good varies (i.e. is variable) depending on the quantity of units shipped. Though there may be fixed cost components to shipping (i.e. an in-house mail distribution network with a personalized weighing and packaging product line), many of the ancillary costs are variable.

Importance of Variable Cost Analysis

Variable costing data can be used in a variety of ways to analyze expenses, pricing, and profitability. Variable cost analysis is important for the following reasons:

  • Variable costs help determine pricing. A company usually strives to competitively price its goods to recover the cost to manufacture the goods. By performing variable cost analysis, a company will better grasp the inputs for its products and what it needs to collect in revenue per unit to make sure its earning money.
  • Variable costs are an integral part of budgeting and planning. A company may plan to double its output next year in an attempt to scale revenue. To do so, it must be aware that variable costs will also proportionally increase. Any strategic plans relating to growth, contraction, or expansion to new products will likely incur changes to variable costs.
  • Variable costs determine the break-even point. A company's break-even point is calculated as fixed costs divided contribution margin, and contribution margin is calculated as revenue - variable costs. A company can leverage variable cost analysis to calculate exactly how many items it needs to see to break-even as well as how many units it needs to sell to make a specific amount of money.
  • Variable costs determine margins and net income. Gross margin, profit margin, and net income calculations are often calculated with a combination of fixed and variable costs. By performing variable cost analysis, a company can easily identify how scaling or decreasing output can impact profit calculations.
  • Variable costs impact a company's expense structure. Imagine a company 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 company as a company's expense structure determines its leverage.

Variable Cost vs. Average Variable Cost

Variable cost and average variable cost may sound similar, but each describe an entirely different value of expenses. While variable cost is usually used to describe the variable cost for a single product, average variable cost often analyzes production over time and compares variable costs to what has been produced. 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 increase or pricing discounts. Consider the variable cost of a project that has been worked on for years. An employee's hourly wages are a variable cost; however, that employee was promoted last year. The current variable cost will be higher than before; the average variable cost will remain something in between.

Average variable costs is often U-shaped 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. A company may also use this information to shut down a plan if it determines its AVC is higher than its.

Variable Costs vs. Fixed 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 products manufactured and sold. If a business increased production or decreased production, rent will stay exactly the same. Although fixed costs can change over a period of time, the change will not be related to production, and as such, fixed costs are viewed as long-term costs.

There is also a category of costs that falls between fixed and variable costs, known as semi-variable costs (also known as semi-fixed costs or mixed costs). These are costs composed of a mixture of both 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 cost is often still incurred.

In general, companies with a high proportion of variable costs relative to fixed costs are considered to be less volatile, as their profits are more dependent on the success of their sales.

Special Considerations

Relevant Range

The concept of relevant range primarily relates to fixed costs, though variable costs may experience a relevant range of their own. This may hold true for tangible products going into a good as well as labor costs (i.e. it may cost overtime rates if a certain amount of hours are worked). Consider wholesale bulk pricing that prices goods by tiers based on quantity ordered.

For example, raw materials may cost $0.50 per pound for the first 1,000 pounds. However, orders of greater than 1,000 pounds of raw material 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. In short, fixed costs are more risky, generate a greater degree of leverage, and leaves the company with greater upside potential. On the other hand, variable costs are safer, generate less leverage, and leave the company with smaller upside potential.

Consider the example above with a company choosing between renting a piece of equipment for $1,000 or $0.05:

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

The company faces the risk of loss if it produces less than 20,000 units. However, anything above this has limitless potential for yielding benefit for the company. Therefore, leverage rewards the company 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 contribution margin, the amount of proceeds a company collects 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 for, every 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 targets 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 sugar, 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 vary.

 

 

 

1 cake

 

2 cakes

 

7 cakes

 

10 cakes

 

0 cakes

 

Cost of sugar, flour, butter, and milk

 

$5

 

$10

 

$35

 

$50

 

$0

 

Direct labor

 

$10

 

$20

 

$70

 

$100

 

$0

 

Total variable cost

 

$15

 

$30

 

$105

 

$150

 

$0

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 zero.

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

Profits = S a l e s T o t a l   C o s t s \begin{aligned} &\text{Profits} = Sales - Total~Costs\\ \end{aligned} Profits=SalesTotal 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. Decreasing costs usually means decreasing variable costs.

If the bakery sells each cake for $35, 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, rent, and insurance, its monthly profit will look like this:

Number Sold Total Variable Cost Total Fixed Cost Total Cost Sales Profit
20 Cakes $300 $900 $1,200 $700 $(500)
45 Cakes $675 $900 $1,575 $1,575 $0
50 Cakes $750 $900 $1,650 $1,750 $100
100 Cakes $1,500 $900 $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 equal 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 = G r o s s   P r o f i t S a l e s = ( S a l e s V C ) S a l e s where: V C = Variable Costs \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(SalesVC)where:VC=Variable Costs

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.

What Are Some Examples of Variable Costs?

Common examples of variable costs include costs of goods sold (COGS), raw materials and inputs to production, packaging, wages, and commissions, and certain utilities (for example, electricity or gas that increases with production capacity).

How Do Fixed Costs Differ From Variable Costs?

Variable costs are directly related to the cost of production of goods or services, while fixed costs do not vary with the level of production. Variable costs are commonly designated as COGS, whereas fixed costs are not usually included in COGS. Fluctuations in sales and production levels can affect variable costs if factors such as sales commissions are included in per-unit production costs. Meanwhile, fixed costs must still be paid even if production slows down significantly.

How Can Variable Costs Impact Growth and Profitability?

If companies ramp up production to meet demand, their variable costs will increase as well. If these costs increase at a rate that exceeds the profits generated from new units produced, it may not make sense to expand. A company in such a case will need to evaluate why it cannot achieve economies of scale. In economies of scale, variable costs as a percentage of overall cost per unit decrease as the scale of production ramps up.

Is Marginal Cost the Same As Variable Cost?

No. Marginal cost refers to how much it costs to produce one additional unit. The marginal cost will take into account the total cost of production, including both fixed and variable costs. Since fixed costs are static, however, the weight of fixed costs will decline as production scales up.

What Is the Formula for Total Variable Cost?

Because variable costs scale alongside, every unit of output will theoretically have the same amount of variable costs. Therefore, total variable costs can be calculated by multiplying the total quantity of output by the unit variable cost.

The Bottom Line

In a manufacturing process, there are different types of costs. One of those cost profiles is a variable cost that only increases if the quantity of output also increases. While a fixed cost remains the same over a relevant range, a variable cost usually changes with every incremental unit produced. Though this cost structure protects a company in the event demand for their good decreases, it limits the update profit potential the company could have received with a more fixed-cost focused strategy.