Understanding a business’s cost structure is important for making sound financial decisions. A component of this structure is variable cost, which reflects a company’s production activity. Calculating this figure allows a business to gain insight into its operational efficiency and profitability at different levels of output. This guide explains what these costs are and how to compute them.
What Are Variable Costs
Variable costs are expenses that change in proportion to the volume of goods or services a business produces. If a company increases its production, its variable costs will rise; if production slows down, these costs will decrease. This direct relationship between cost and output distinguishes them from fixed costs, which remain constant regardless of production levels, such as rent, administrative salaries, or insurance premiums.
To illustrate, consider a bakery. The flour, sugar, and eggs used to bake a cake are all variable costs. The more cakes the bakery produces, the more of these ingredients it must purchase. The wages paid to bakers for the time they spend actively making cakes are a direct labor cost, which is also variable.
Other examples include the tires and steel for a car manufacturer or packaging and shipping expenses for an online retailer. Sales commissions also fit this category, as they are a percentage of sales and thus rise and fall with revenue.
The Variable Cost Formula
To determine the total variable cost, a formula is used that relies on two pieces of information: the quantity of goods produced and the cost to produce each item.
The formula is expressed as: Total Variable Cost = Total Quantity of Output x Variable Cost Per Unit of Output. In this equation, the “Total Quantity of Output” represents the total number of items a company has produced over a specific period. The “Variable Cost Per Unit of Output” is the combined cost of all labor and materials needed to create a single unit of a product.
How to Calculate Total Variable Cost
Applying the formula is a methodical process. Using an example of a business that produces custom t-shirts can clarify the calculation.
The first step is to identify all the costs that go into making a single t-shirt. This requires a list of every material and direct labor expense. For a t-shirt business, this would include the price of one blank shirt, the amount of ink used for the design, and the cost of the packaging materials.
Next, these individual per-unit costs are summed to find the total variable cost for one unit. If a blank t-shirt costs $4.00, the ink for the design costs $1.50, and the packaging materials cost $0.50, the total variable cost per unit is $6.00 ($4.00 + $1.50 + $0.50).
The third step involves determining the total quantity of output for the period being analyzed. Let’s assume the t-shirt company produced 500 custom shirts in a month. This number is the multiplier that will be used to scale the per-unit cost to a total figure for the entire production run.
Finally, the formula is applied by multiplying the total per-unit cost by the total number of units produced. For the t-shirt business, the calculation would be $6.00 (Variable Cost Per Unit) x 500 (Total Quantity of Output), which equals $30,000.
Calculating Average Variable Cost
A related and equally useful metric is the average variable cost (AVC). This figure represents the variable cost on a per-unit basis. Businesses calculate AVC to understand the cost of producing one additional unit, which helps in making decisions about production levels and pricing. It provides a standardized cost that can be tracked over time to monitor efficiency.
The formula for this calculation is: Average Variable Cost = Total Variable Cost / Total Quantity of Output.
Using the figures from the t-shirt business example, the total variable cost was $30,000 for producing 500 shirts. By dividing the total variable cost ($30,000) by the total quantity of output (500), the average variable cost is found to be $6.00 per shirt. This provides a baseline for future analysis.
Why Calculating Variable Cost Is Important
Calculating variable costs is a foundation for strategic business decisions. This knowledge directly impacts how a company prices its products, plans for growth, and assesses its overall financial health. By analyzing these fluctuating expenses, managers can make more informed choices that drive profitability.
One of the most direct applications is in setting a pricing strategy. To ensure profitability, a product’s price must be higher than the cost to produce it. Knowing the variable cost per unit allows a business to establish a price floor, ensuring that every sale covers its own direct costs and contributes to paying off fixed costs.
This leads to the concept of break-even analysis. A business reaches its break-even point when its total revenue equals its total costs. The variable cost is a component for calculating the contribution margin, which is the selling price per unit minus the variable cost per unit. By dividing total fixed costs by the contribution margin, a company can determine the number of units it needs to sell to cover all its expenses.
Analyzing variable costs is also part of profitability analysis and decision-making. It allows a company to see how scaling production up or down will impact its bottom line. For instance, if a business is considering a large, one-time special order at a discounted price, it can use variable cost data to see if the proposed price is high enough to cover production costs and contribute to profit.