Every action has an equal and opposite reaction.”
This quote can apply to most situations but is multifold in business: more money and more sales mean more problems. Variable cost is all about adapting to production changes when there are more sales through your company. Here’s a complete guide to understanding variable cost, its formula, and its depth in the expense criteria.
Table of Contents
What is Variable Cost?
To give you the most simple definition, Variable costs are costs that change as the quantity of a company’s product or service changes. In other words, it is the sum of marginal costs for all units. For example, when the components of the raw materials increase per unit, the production costs also increase based on the number of units.
Variable costs vary according to output quantity. In other words, increasing output raises costs, while decreasing output lowers costs. As a result, variable costs could be considered direct costs of production volume, rising in response to increased production and falling in response to decreased production.
Variable Cost Examples
These are some of the components representing the common types of variable costs.
- Raw Materials
Raw materials or direct materials are all the components used to produce or manufacture a product. So, raw materials are the cost of all the materials used to finish particular merchandise. These tangible materials should be quantifiable and identifiable as contributing to the product. Steel, cement, and circuit cables are some raw materials for which the variable costs can be calculated. These are the base materials and can be identifiable for their contribution to merchandise.
- Package Materials
Packaging materials include bags, boxes, twist ties, plastic wrappers, and foil. When determining product profitability, most businesses consider the cost of packaging materials. Because the amount used varies depending on the volume of sales and production, the costs for the materials used for packaging goods are variable. When the production or sales volume decreases, some companies reduce the number of packaging materials used for that product, resulting in fewer sales and less expense.
- Sales Commissions
Commissions are the amount that employees get for the number of products they sell, and this cost may increase or decrease per the production cost. This amount falls under the variable cost section as employees are paid only as per their sales target. If they sell more than the target intended, they receive commissions, and if it’s less than the target, they could get a reduced pay.
- Shipping Costs
Shipping costs are the expenses incurred by a company when transporting raw materials or delivering finished goods. Shipping costs vary according to a company’s sales and production volumes, and these costs typically rise with higher production and sales volumes and lower production and sales volumes.
- Credit Card Fees
These fees are for businesses that accept credit cards as a form of payment from their customers. The variable cost, in this case, is the unpredictable amount of transaction fees each month, as opposed to a fixed monthly fee.
How to Calculate the Variable Cost?
The total variable cost is determined by calculating the price per unit. While fixed costs are added together to determine the company’s total cost, variable costs are multiplied by the cost by unit.
Variable Cost = Total Quantity of Products x Variable cost per unit
For example, an apparel company gets an order for 300 tops for INR 300 each. To find the variable cost per unit, we take the cost per unit in materials (INR 25) and direct labour costs (INR 30).
300 x (0.25 + 0.30) = 165
Total variable costs would be 165, meaning gross profit would be 135 (300 – 165).
Knowing and calculating fixed and variable costs can help people make a better saving plan for their company and result in no loss.
Variable Cost and Fixed Cost
Fixed and variable costs are both incurred in a business. Variable expenditures, as previously stated, do not remain constant as output demand changes. Fixed costs do not change regardless of output levels (such as salary). It’s crucial to know which costs are variable and fixed while making business decisions.
Rent, staff pay, insurance, and office supplies are fixed costs. Regardless of the volume of products created and sold, a firm must pay its rent for the office it occupies. Rent will remain constant irrespective of whether a company’s output increases or decreases.
Variable costs, as mentioned above, will have fluctuations according to the production and profit categories; when there is more demand, there will be more expense and less need and fewer sales, resulting in less production cost.
Importance of Variable Costs
In marketing, it’s critical to understand how variable and fixed expenditures are allocated. This distinction is vital when estimating the revenues generated by various changes in unit sales and, as a result, the financial impact of planned marketing strategies.
- Increase Profitability – A company’s success frequently depends on its ability to make informed predictions about how different operating conditions will affect the business venture. One of the most critical factors in making such predictions is determining the fixed-to-variable cost ratio. Variable costs based on production and sales volumes will significantly impact the company’s profitability.
- Avoid Unnecessary Expense – Both fixed and variable costs are incurred at every stage in a business. Fixed costs can also change at a rare occurrence, but it is possible as these changes can occur for salaries when there’s a layoff in the company. Variable costs can also be avoided when we recognize the cost occurrence for each product and save more on the excessive production of out of demand products.
- Set Targets– Rising variable-cost expenses should not be a negative indicator. To meet higher sales targets, it is always necessary to increase production, which can incur additional costs. When a company strives to achieve a higher revenue target, variable costs tend to rise in tandem.
While variable costs, total variable costs and fixed cost calculation ratio often seem complicated, these terms represent the nature of the expenses for every business growth. Understanding these terms and how they impact your business makes it better to prepare for evolving market competition and reduce the impact of variable costs on your business.