A company’s expenses fall into different categories with distinct behaviors. Properly classifying these expenses is part of sound financial management and strategic planning. This article explores one of the primary categories of business expenses: variable costs.
What Are Variable Costs?
Variable costs are business expenses that change in direct proportion to a company’s production or sales volume. As a company produces more goods or services, its variable costs increase, and as production declines, these costs decrease. This direct link to output is their defining characteristic.
Imagine a small bakery. The flour, sugar, and eggs used to bake bread are classic examples of variable costs. If the bakery doubles its daily production of loaves for a holiday, its expenditure on these ingredients will also double. If it halves production during a slow month, the cost of these raw materials will fall by the same measure.
This direct fluctuation means the total variable cost is not a static number but a dynamic figure that moves with a business’s activity. Understanding this concept allows managers to predict expenses based on anticipated production levels, which is a foundational part of analyzing a company’s cost structure.
Common Examples of Variable Costs
Direct Materials
Direct materials are the raw ingredients physically part of the final product. For a furniture manufacturer, this includes the wood, screws, and varnish used to create a table. For a clothing company, it is the fabric, thread, and buttons that make up a shirt. Producing more units requires a proportionally larger quantity of these materials.
Direct Labor
Direct labor refers to the wages paid to workers directly involved in the production process, such as employees paid hourly to operate machinery or assemble products. If a company increases its production schedule by adding an extra shift, the total amount paid in hourly wages will rise accordingly.
Production Supplies
Production supplies are items consumed during the manufacturing process that are not part of the final product. These can include machine oil, welding rods, cleaning agents for equipment, or disposable safety gear for workers. The consumption of these supplies is tied to production activity.
Packaging and Shipping
The costs associated with preparing a product for delivery are incurred only when a unit is sold and dispatched. This includes expenses for boxes, protective wrapping, labels, and postage or courier fees. These expenses rise and fall with sales volume.
Sales Commissions
In many businesses, salespeople earn a commission, which is a percentage of the sales revenue they generate. This compensation structure makes sales commissions a variable cost. The total expense for commissions is directly tied to the total revenue generated.
Utility Bills
Certain utility costs can be classified as variable. While the electricity for office lighting is a fixed cost, the electricity needed to power production machinery is variable. The more hours a factory runs its assembly lines, the more electricity it consumes, leading to a higher bill.
Variable Costs Versus Fixed Costs
Fixed costs are the counterpart to variable costs. They are expenses that do not change regardless of the level of production or sales, such as monthly rent, insurance premiums, and administrative salaries. Even if a company produces zero units, it must still pay its fixed costs.
Variable costs fluctuate with production, while fixed costs remain constant. This means the variable cost per unit stays the same. For example, if the wood for one chair costs $25, the cost for 100 chairs is $2,500, keeping the per-unit cost at $25. In contrast, the fixed cost per unit changes. If monthly rent is $5,000 and the company produces 100 chairs, the rent cost per chair is $50, but if production increases to 1,000 chairs, the allocated rent per chair drops to $5.
This distinction impacts strategic business planning. A business with high fixed costs has a different risk profile and pricing structure than one where most costs are variable. Understanding this balance informs decisions about pricing and expansion.
How to Calculate Variable Costs
Calculating the total variable cost for a specific period is a straightforward process. It requires the cost to produce a single unit and the total number of units produced. The formula is as follows: Total Variable Costs = Cost Per Unit x Total Number of Units Produced.
For instance, consider a company that manufactures headphones. If the variable cost per unit (direct materials, labor, etc.) is $50 and the company produces 2,000 units in a month, the total variable cost is calculated as follows: $50 (Cost Per Unit) x 2,000 (Total Units) = $100,000 (Total Variable Costs).
A business can also determine its Average Variable Cost (AVC) by dividing the total variable costs by the total output. While the variable cost per unit is often known beforehand, the AVC is valuable for analyzing past performance, especially if per-unit costs have fluctuated. This figure helps track production efficiency over time.
The Importance of Understanding Variable Costs
Understanding variable costs directly informs a company’s pricing strategy. For a business to be profitable, a product’s price must be set above its total variable cost per unit. The amount by which the selling price exceeds the variable cost is the contribution margin. This is the money available to cover fixed costs and generate profit.
This information is also used in break-even analysis. By knowing both variable and fixed costs, a company can calculate the number of units it needs to sell to cover all expenses. This break-even point is a target for sales teams and a benchmark for profitability, as any sales above it contribute to the company’s bottom line.
Knowledge of variable costs aids in accurate budgeting and financial forecasting. When planning for growth, a business can predict how total costs will increase as it scales production. This allows for more realistic budgets and helps in securing financing for expansion. It also enables managers to assess the profitability of different products, helping them decide which lines to promote or discontinue.