What is a Variable Cost? Definition, Example, Formula, and More
Few things in life never change, consisting of the costs of doing your business. When expenses change in relation to the operations of your business, these are known as variable costs. Together with fixed costs, variable costs play a crucial part in revealing your company’s profitability.
So, in this blog post, let’s unpack one of the most important and useful financial figures to a growing business: variable cost.
Let’s get started right now!
Table of contents
- What is a variable cost?
- Variable cost examples
- The importance of a variable cost
- How to calculate variable costs
- Variable costs vs. Fixed costs
- Is salary a fixed or variable cost?
- How to manage your variable costs effectively
- 1. Determine the annual average for each variable expense
- 2. Add a buffer
- 3. Always compare the actual spending to your estimates
- 4. Reduce your actual variable costs if necessary
- 5. Create a savings account for variable costs
- 6. Reassess your variable costs annually
- 7. Obtain a line of credit for emergencies
- The final verdict
What is a variable cost?
A variable cost, or variable expense, is the price of raw materials, distribution, and labor associated with each unit of product/ service you sell. Variable costs increase or decrease depending on your company’s production volume; they raise as your production increases and fall as production decreases.
Variable costs vary because they can increase or decrease when you make more or less of your product/ service. The more units you sell, the more money you will make, but some of this money needs to pay to produce more units. Therefore, you will need to produce more units to actually generate a profit.
Some industries with high fixed costs, like airlines, are less vulnerable to competition. That’s because they require vast amounts of investment in machinery and other physical items to start up.
Meanwhile, industries with high variable costs, like the service industry, that depends heavily on labor, are much more vulnerable to competition because less investment is required to start up.
Variable cost examples
One of the simplest ways to determine whether a cost is variable or fixed is seeing whether it changes monthly or stays the same every month. There are a lot of variable costs that a business incurs monthly, but the following are the most common ones:
Cost of raw materials. Perhaps these are the largest variable cost of most businesses. Raw materials are used to create your finished product, and their cost will always vary depending on your production levels.
Direct labor costs (i.e., hourly wages). For example, managers may get their employees to work an extra shift and need to pay over time. Additional employees can also be added to the production line when the levels are up, or subsequently furloughed when the levels of production drop. While not all wages are impacted by production, the wages of direct employees are.
Manufacturing supplies. These items are directly related to the manufacturing process, for instance, gloves for machine workers or equipment cleaning supplies. Since these costs can vary based on your production labels, manufacturing supplies are always considered variable costs.
Commissions. While commissions aren’t included in the cost of goods sold, they’re variable costs that increase or decrease depending on production levels. The higher your production levels are, the more commissions you should be paying, or your sales staff isn’t doing its job.
Distribution costs (i.e., shipping, restocking). If you sell directly, you will incur the cost of shipping to your customers, while if you are shipping in bulk to a store or distributor, you’ll pay freight costs. Either way, the shipping costs increase along with production levels.
Credit card transaction fees. These costs are associated with using credit cards for payments.
Online payment partners. Some apps like PayPal often charge businesses per transaction, so customers can check out purchases through the app. The more orders you receive, the more you need to pay for the app.
Let’s take a specific example for you to figure out quickly. Say you’re running an E-commerce business, which maintains a small warehouse, and you have to pay hourly staff. Hours worked vary depending on the number of orders. Plus, shipping costs are a high variable cost for your business. And your company has a salesperson who gets commission and a performance bonus.
The importance of a variable cost
Variable costs are hugely essential to a business as it can significantly impact how a company spends its money. Depending on your business’s strategic goals, variable costs can be quite high (in the case of a lot of change) or quite low. If your variable expenses are low, you’ll have more budget to spend in other areas, as there will be no sudden costs incurred.
It’s worth mentioning that rising costs isn’t necessarily a negative signal when viewing your business’s income statement. It can actually indicate an increase in sales, which would require more costs to produce the number of goods in demand. Then, this translates to increased revenue over the longer term.
So, keeping track of variable costs can provide crucial insight into where cash outflow is going and to what extent. Your business profits can be directly impacted by adjusting the variable costs but maintaining sales prices.
How to calculate variable costs
The following formula could be used to compute your total variable cost:
Total variable cost = Variable cost of each output unit x Total output quantity
Follow these steps when applying this formula to determine your company’s total variable cost: #1. Identify all variable expenses associated with the production of one product unit #2. Add all variable expenses required to produce one unit in order to get the total variable cost for one unit of production #3. Multiple the variable costs for one product unit by the total number of units produced. The sum of this calculation gives you the total variable cost.
For example, your company wants to calculate the total variable cost required to produce 100 products. To calculate the total variable cost, you first need to determine your variable cost per unit for each product produced. You get the following numbers:
- Direct material costs per unit: $10
- Direct labor costs per unit: $20
- Shipping costs: $8
The variable expenses to produce one unit is $10 + $20 + $8 = $38. This means that to make one product, you must spend $38.
To compute the total variable cost to produce 100 products, you need to spend: $38 x 100 = $3,800. This means that the total variable expense required to produce 100 units is $3,800.
Variable costs vs. Fixed costs
Another important type of costs often incurred in the production of products or services, as we mentioned above, are fixed costs. They are expenses that remain the same regardless of your production output. Whether your business makes sales or not, you must pay your fixed costs, as these costs are independent of output.
Fixed costs remain the same month to month, which makes them predictable. If your fixed costs add up to $1,000 per month, you know you will need to make at least that much money to stay in business.
However, that predictability comes with side effects. Fixed expenses tend to be rigid and hard to change, such as rent or insurance fees. So, when it comes to cutting expenses and increasing your profit margins, fixed costs are the most difficult ones to tackle. Variable costs, on the other hand, tend to be more flexible. Variable expenses are often the first thing to get cut when businesses want to increase their profit margin.
In case the differences between the two still seem unclear, you can read our below comparison table for more information.
Is salary a fixed or variable cost?
Salary is a fixed cost, which doesn’t vary based on production or revenue. It is a regular recurring expense and the amount paid out is set.
That said, there may be variable expenses on top of a salary. Piece rate labor is one of these forms. Workers get paid based on every unit they made. Or, employees that are paid based on billable hours is another variable expense. This occurs when a business bills a client for the hours its employees work - they only get paid depending on the hours the company can bill.
The commission is also a variable cost as salespeople get paid only when they sell a product or service.
How to manage your variable costs effectively
While variable expenses are tied to output changes, this doesn’t necessarily mean that as your business grows, your variable costs must rise in a linear fashion. In other words, if you increase your production by 10%, it doesn’t mean that your variable expenses will also go up by exactly that amount.
As a matter of fact, there are many ways for you to manage your variable costs effectively. Some of them include:
1. Determine the annual average for each variable expense
When you determine the annual average for a variable cost, avoid the temptation to only look at the past 12 months. Spend time reviewing the average of three years’ worth of variable costs.
By doing so, you can account for anomalies that may impact your average for an expense. If you haven’t taken steps to permanently reduce a variable cost, err on the side of caution and use the highest average amount.
2. Add a buffer
Once you’ve determined the average for each variable cost, add a buffer to it. A buffer of 3%-5% should be more than enough to cover price increases, and most anomalies that result in an outlier year for the expense. If you want to be more cautious, and if your budget can handle it, build in a buffer of 10%.
3. Always compare the actual spending to your estimates
At the end of each month, go back and compare what you ended up spending to what your estimates. How off are you? Note if you were over-budget or under-budget for each expense category.
If you were within your cushion, you would likely be on track to have a similar result next month. If not, you should go back to the drawing board and assess where you can shift some of your money over or even away from your variable expenses fund.
4. Reduce your actual variable costs if necessary
If your business is struggling with the lack of predictability or desiring to cut costs, you may be looking to cut your overall variable expenses.
However, you should thoroughly analyze this process and see if there are any ways you can produce similar output even after cost-effective changes are made to this process. Some examples include:
Assessing your product or service. Many businesses offer different products and services. You could be selling things as a package, but it is only a portion of the package that is actually generating revenue. So, should you eliminate certain features? Are there any ways you could deliver your product/ service faster?
Raw materials. Are you using the most cost-effective materials? Can you buy it in large quantities? If you purchased better materials, would you have fewer issues with your product down the road?
Labor. Is there anything that can be outsourced or automated that wouldn’t affect quality? Can you boost your workforce’s efficiency and more output by providing them with specific tools or services?
Commissions. While cutting commissions is an option, it is always best to cut other costs before reducing employee incentives such as commissions, which may affect your human resource management or even your sales.
Keep in mind that because something has always been done in a certain way doesn’t mean it is right. As your business grows, you can become overwhelmed and don’t have time to tear apart your current processes and systems as much you like. However, given how much the market can change and costs can evolve, doing this could really help your company identify areas to save on variable expenses.
5. Create a savings account for variable costs
If you wisely budgeted and ended up with a little extra, deposit that amount of money in savings accounts to help deal with price spikes. This will create a reserve that you can draw from during months when your expenses are higher than usual.
6. Reassess your variable costs annually
You might be tempted to reuse the same variable cost projections in your budget each year, especially when you’ve saved a decent amount in your savings account. Avoid this temptation. It’s better to reassess your variable costs annually to control your business operations better.
7. Obtain a line of credit for emergencies
Sometimes the best-laid plans can go awry. Instead of letting things fall apart, consider a business line of credit as a backup plan. This revolving financing form is handy because you don’t need to re-apply once you pay off your first draw and only pay interest on what you have taken out.
Line of credit has higher credit limits than credit cards and lets you withdraw cash, giving you the freedom to pay for major costs without delay.
The final verdict
Understanding what a variable cost is and knowing how to manage it effectively is critical to achieving your business’s sustainability and growth. Always remember that: don’t ignore your variable costs once your sales grow.
We hope this blog post has given you the necessary knowledge of variable costs. If you have any questions or concerns about this topic, please let us know. We’re always here to hear from you!