Variable Cost: What It Is and How to Calculate It

However, anything above this has limitless potential for yielding benefit for the company. Therefore, leverage rewards the company not choosing variable costs as long as the company can produce enough output. Therefore, a company can use average variable costing to analyze the most efficient point of manufacturing by calculating when to shut down production in the short-term.

A variable cost is a cost that varies in relation to changes in the volume of activity. A variable cost increases as the level of activity increases; for example, the total cost of direct materials goes up in conjunction with increases in production volume. The variable cost concept can be used to model the future financial performance of a business, as well as to set minimum price points. The marginal cost will take into account the total cost of production, including both fixed and variable costs. Since fixed costs are static, however, the weight of fixed costs will decline as production scales up. A company that seeks to increase its profit by decreasing variable costs may need to cut down on fluctuating costs for raw materials, direct labor, and advertising.

• In general, a company should spend roughly the same amount on raw materials for every unit produced assuming no major differences in manufacturing one unit versus another.
• Variable cost and average variable cost may not always be equal due to price increase or pricing discounts.
• Along the manufacturing process, there are specific items that are usually variable costs.
• A variable cost increases as the level of activity increases; for example, the total cost of direct materials goes up in conjunction with increases in production volume.
• Raw materials are the direct goods purchased that are eventually turned into a final product.
• A company in such a case will need to evaluate why it cannot achieve economies of scale.

A company must still pay its rent for the space it occupies to run its business operations irrespective of the volume of products manufactured and sold. If a business increased production or decreased production, rent will stay exactly the same. Although fixed costs can change over a period of time, the change will not be related to production, and as such, fixed costs are viewed as long-term costs.

In general, it can often be specifically calculated as the sum of the types of variable costs discussed below. Variable costs may need to be allocated across goods if they are incurred in batches (i.e. 100 pounds of raw materials are purchased to manufacture 10,000 finished goods). As the production output of cakes increases, the bakery’s variable costs also increase.

What Is the Formula for Total Variable Cost?

Direct labor may not be a variable cost if labor is not added to or subtracted from the production process as production volumes change. This situation arises when a production line must be fully staffed, irrespective of the amount of production volume. This is a common situation in large and complex assembly lines, where all positions must be staffed before operations can commence. Raw materials is depreciation expense an administrative expense are the direct goods purchased that are eventually turned into a final product. If the athletic brand doesn’t make the shoes, it won’t incur the cost of leather, synthetic mesh, canvas, or other raw materials. In general, a company should spend roughly the same amount on raw materials for every unit produced assuming no major differences in manufacturing one unit versus another.

• If companies ramp up production to meet demand, their variable costs will increase as well.
• Therefore, the cost of shipping a finished good varies (i.e. is variable) depending on the quantity of units shipped.
• The concept of relevant range primarily relates to fixed costs, though variable costs may experience a relevant range of their own.
• This is a common situation in large and complex assembly lines, where all positions must be staffed before operations can commence.

A company may also use this information to shut down a plan if it determines its AVC is higher than its. Fixed costs are expenses that remain the same regardless of production output. Whether a firm makes sales or not, it must pay its fixed costs, as these costs are independent of output. When the manufacturing line turns on equipment and ramps up product, it begins to consume energy. When its time to wrap up product and shut everything down, utilities are often no longer consumed. As a company strives to produce more output, it is likely this additional effort will require additional power or energy, resulting in increased variable utility costs.

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In addition, variable costs are necessary to determine sale targets for a specific profit target. Commissions are often a percentage of a sales proceeds that is awarded to a company as additional compensation. Because commissions rise and fall in line with whatever underlying qualification the salesperson must hit, the expense varies (i.e. is variable) with different activity levels. The athletic company also won’t incur some types labor if it doesn’t produce more output. Some positions may be salaried; whether output is 100,000 units or 0 units, certain employees will receive the same amount of compensation.

How Do Fixed Costs Differ From Variable Costs?

For others that are tied to an hourly job, putting in direct labor hours results in a higher paycheck. Along the manufacturing process, there are specific items that are usually variable costs. For the examples of these variable costs below, consider the manufacturing and distribution processes for a major athletic apparel producer. For example, raw materials may cost $0.50 per pound for the first 1,000 pounds. However, orders of greater than 1,000 pounds of raw material are charged $0.48. In either situation, the variable cost is the charge for the raw materials (either $0.50 per pound or $0.48 per pound).

Variable costs are commonly designated as COGS, whereas fixed costs are not usually included in COGS. Fluctuations in sales and production levels can affect variable costs if factors such as sales commissions are included in per-unit production costs. Meanwhile, fixed costs must still be paid even if production slows down significantly. If companies ramp up production to meet demand, their variable costs will increase as well. If these costs increase at a rate that exceeds the profits generated from new units produced, it may not make sense to expand.

The cost to package or ship a product will only occur if certain activity is performed. Therefore, the cost of shipping a finished good varies (i.e. is variable) depending on the quantity of units shipped. Variable cost and average variable cost may not always be equal due to price increase or pricing discounts. An employee’s hourly wages are a variable cost; however, that employee was promoted last year. The current variable cost will be higher than before; the average variable cost will remain something in between. For this reason, variable costs are a required item for companies trying to determine their break-even point.

Overhead is not a variable cost, since overhead costs will be incurred, irrespective of production levels. For example, both rent and machine depreciation, which are overhead costs, will be incurred even if there is no production activity. A cost that changes in total in proportion to changes in volume of activity is a variable cost.

Variable costs are usually viewed as short-term costs as they can be adjusted quickly. For example, if a company is having cashflow issues, they may immediately decide to alter production to not incur these costs. Completing the challenge below proves you are a human and gives you temporary access.

Understanding Variable Costs

Every dollar of contribution margin goes directly to paying for fixed costs; once all fixed costs have been paid for, every dollar of contribution margin contributes to profit. Let’s assume that it costs a bakery $15 to make a cake—$5 for raw materials such as sugar, milk, and flour, and $10 for the direct labor involved in making one cake. The table below shows how the variable costs change as the number of cakes baked vary.

Example of a Variable Cost

However, the cost cut should not affect product or service quality as this would have an adverse effect on sales. By reducing its variable costs, a business increases its gross profit margin or contribution margin. One of those cost profiles is a variable cost that only increases if the quantity of output also increases. While a fixed cost remains the same over a relevant range, a variable cost usually changes with every incremental unit produced. Variable costs are directly related to the cost of production of goods or services, while fixed costs do not vary with the level of production.

Variable and fixed costs play into the degree of operating leverage a company has. In short, fixed costs are more risky, generate a greater degree of leverage, and leaves the company with greater upside potential. On the other hand, variable costs are safer, generate less leverage, and leave the company with smaller upside potential. A variable cost is a corporate expense that changes in proportion to how much a company produces or sells. Variable costs increase or decrease depending on a company’s production or sales volume—they rise as production increases and fall as production decreases.

Formula and Calculation of Variable Costs

Because variable costs scale alongside, every unit of output will theoretically have the same amount of variable costs. Therefore, total variable costs can be calculated by multiplying the total quantity of output by the unit variable cost. There is also a category of costs that falls between fixed and variable costs, known as semi-variable costs (also known as semi-fixed costs or mixed costs). Costs are fixed for a set level of production or consumption and become variable after this production level is exceeded. Variable costs are a direct input in the calculation of contribution margin, the amount of proceeds a company collects after using sale proceeds to cover variable costs.