what Are Variable Costs?
Variable costs are costs that vary according to a business’s output of products or services.
Generally, variable costs are tied directly to unit costs. This means that the more units that are produced, the higher variable costs will climb. Conversely, as less units are produced, variable costs will fall.
The concept of variable costs is most closely associated with manufacturing, but all businesses can find variable costs on their balance sheets.
How Do Variable Costs Work?
Costs are broadly classified as fixed or variable.
Fixed costs do not change with the output of a business, but variable costs do. Fixed costs commonly include expenses such as rent. In the case of rent, the business must pay each month regardless of the amount of business they conduct.
Variable costs, on the other hand, are directly related to products or services. Common variable costs include the following:
- Raw materials
- Supplies needed to execute a service
- Shipping charges
- Credit card processing fees
In the case of raw materials, the more units a business produces, the more materials they will need. In the case of a service business such as a quick service auto shop, the more customers they have, the more oil, filters, and other supplies will be needed to serve those customers. The same goes for shipping charges or processing fees—the more units sold, the higher those variable costs will ultimately rise.
Calculating Variable Cost
Arriving at an accurate calculation of variable costs is important both for accounting purposes and to make the best possible business decisions.
Determining variable cost is a three-step process that consists of recording and classifying costs, determining a total variable cost, and directly calculating the variable cost per unit.
Recording and Classifying Costs
We already know that variable costs are those that change with output. To classify the costs incurred by your business, ask yourself this question: if I produced or sold to more or fewer customers, would this cost change?
If so, it’s a variable cost. If not, it’s a fixed cost.
Let’s use the table below as a sample grouping of costs.
We can see in the sample table that not all of the costs shown are variable costs.
Building rent and equipment leasing costs are due as periodic payments regardless of usage—even if the equipment is never turned on, the lease payments are still required.
These expenses are fixed costs.
Determining Total Variable Costs
Add together all variable expenses to arrive at a total variable cost for the period you are examining.
The period could be a week, a month, a year—whatever makes sense for you to examine and report. Using our sample table, we can see that the total for variable costs is $29,050.
Calculating Variable Cost Per Unit
Finally, to calculate the variable cost per unit, use the following formula with the data you have determined so far.
Here, lower case v represents the unit variable cost (the number we are looking for), capital V is the total variable cost, and Q is the quantity produced.
Let’s say that our sample data covers a month and in that period 33,000 units were produced. Let’s look at that formula again with our sample data plugged in.
Therefore, we find that our variable cost per unit equals $0.88. This means that for every unit produced we are spending eighty-eight cents in variable costs.
Why Calculate Variable Cost?
Now that we know the variable expenses for our business and for each unit produced, what can we do with this information?
Tracking costs in a business is absolutely crucial to managing the financial health of the business and setting appropriate, achievable goals.
Because variable costs aren’t set in stone in the way that fixed costs are, it is in the best interest of managers to find ways to reduce variable costs.
Even shaving pennies off the variable costs per unit can result in massive cost savings for a company. Businesses of a sufficient size can achieve these savings through leveraging the economies of scale.
Calculating and understanding variable costs is also a critical component in determining the break-even point of a business.
If fixed costs remain the same and we know the variable cost of each unit, then, using the break-even formula, we can calculate how many units we need to sell in order to pass the break-even point and turn a profit.