  # Variable Cost

Understand the Concept of Variable Costs  • What is the definition of a variable cost?
• What are some examples of variable costs?
• What is the difference between a variable cost and a fixed cost?
• How can you determine whether a cost is a variable or fixed cost?

## Variable Cost Definition

Variable costs fluctuate depending on the production output in a given period.

Variable costs are directly connected to production volume, i.e. the relationship between these costs and production output is directly linked.

Since variable costs are output-dependent, the costs incurred increase (or decrease) given varying production volumes.

If product demand (and the coinciding production volume) exceed expectations — in response, the company’s variable costs would adjust in tandem.

Generally speaking, a company’s variable costs adjust based on the change in output.

• Increased Production Output → Greater Variable Costs
• Decreased Production Output → Reduced Variable Costs

## Variable Costs vs Fixed Costs

The difference between variable costs and fixed costs are as follows:

• Variable Costs → The amount incurred is directly tied to production volume and fluctuates based on the output in the given period.
• Fixed Costs → The amount incurred remains the same regardless of production volume.

From the viewpoint of management, variable costs are easier to adjust and are more in their “control,” while fixed costs must be paid regardless of production volume.

Unlike variable costs, fixed costs encompass a company’s obligations irrespective of the production output (e.g. rent, insurance premium).

Fixed costs occur periodically based on a pre-determined schedule and are usually easier to predict and budget for.

In contrast, variable costs are typically more difficult to predict, and there is usually more variance between the forecast and actual results.

Why? The amount incurred in variable costs is tied to sales performance and customer demand, which are variables that can be impacted from “random” factors (e.g. market trends, competitors, customer spending patterns).

For example, a company executive’s base salary would be considered a fixed cost because the dollar amount owed by the company is outlined in an employment contract signed by the relevant parties.

But the bonus portion of the executive’s compensation is a variable cost since the bonus is performance-based compensation and contingent on the company reaching certain targets thresholds on performance metrics such as:

Variable costs are directly tied to a company’s production output, so the amount of variable costs incurred fluctuate based on sales performance (and volume).

As more incremental revenue is produced, the growth in the variable costs could offset the monetary benefits from the increase in revenue (and place downward pressure on the company’s profit margins).

## Variable Cost Formula

A company’s total costs consist of the sum of fixed and variable costs.

Total Costs = Fixed Costs + Variable Costs

In the simplest approach, the variable costs are derived by subtracting fixed costs from total costs.

Variable Costs = Total Costs – Fixed Costs

More specifically, variable costs are equal to the total cost of materials plus the total cost of labor, which are the two main types of variable costs.

Variable Costs = Total Cost of Materials + Total Cost of Labor

Alternatively, variable costs can also be calculated by multiplying the cost per unit by the total number of units produced.

Variable Cost = Variable Cost Per Unit × Total Number of Units Produced

## Average Variable Cost Formula

The average variable cost — also known as the variable cost per unit — equals the total variable costs divided by the total output (i.e. units produced)

Average Variable Cost = Total Variable Costs ÷ Output

Calculating the average variable cost can be useful when it comes to assessing how variable costs are changing (i.e. rising or declining) as the company continues to grow.

While variable costs will increase as output increases, the average variable cost helps to ensure that there are no inefficiencies where the variable costs entirely offset the benefit of higher output.

## Variable Cost Example Calculation

Suppose that a consulting company charged 1,000 hours of services to its clientele.

If the total variable costs incurred were \$100,000, the variable cost per unit is \$100.00 per hour.

• Variable Cost Per Unit = \$100,000 Total Variable Costs ÷ 1,000 Hours
• Variable Cost Per Unit = \$100

If the consulting company continues to scale and the number of clients (and hours billed) increases, the variable costs also increase — which can place downward pressure on the company’s profit margins (i.e. requiring more hiring, more complex organizational structure).

## Examples of Variable Costs

Common examples of variable costs are shown in the chart below.

Variable Cost Examples
• Direct Labor
• Direct Material Cost (e.g. Raw Material)
• Sales Commissions
• Management Bonuses
• Employee Stock-Based Compensation
• Shipping Costs

In the case of an e-commerce company, the delivery and shipping fees associated with each sale would be classified as a variable cost, while utilities would be a fixed cost.

If a higher volume of products is produced, the amount of delivery and shipping fees incurred also increases (and vice versa) — but utility costs remain constant regardless.

## Variable Costs and Operating Leverage

Operating leverage is defined as the proportion of a company’s total cost structure comprised of fixed costs rather than variable costs.

• High Operating Leverage → Lower Proportion of Variable Costs
• Low Operating Leverage → Higher Proportion of Variable Costs

If a company has low operating leverage — i.e. a higher percentage of variable costs — then each incremental dollar of revenue can potentially generate lower profits because variable costs would offset any increases in revenue.

However, the risk associated with high operating leverage is that if customer demand and sales are lackluster, then the company is restricted in terms of potential areas for cost-cutting.

In effect, a company with low operating leverage can be at an advantage during economic downturns or periods of underperformance.

Since variable costs are tied to output, lower production volume means fewer costs are incurred, which eases the cost pressure on a company — but fixed costs must still be paid regardless.

## Variable Costs and Break-Even Point

The break-even point refers to the minimum output level in order for a company’s sales to be equal to its total costs.

###### Break-Even Point Formula
• Break-Even Point = Fixed Costs ÷ Contribution Margin

Suppose a company’s cost structure consists of mostly variable costs — in that case, the inflection point at which a company starts to turn a profit is lower (i.e. compared to those with higher fixed costs).

The higher the percentage of fixed costs, the higher the bar for minimum revenue before the company can meet its break-even point.

High operating leverage can benefit companies since more profits are obtained from each incremental dollar of revenue generated beyond the break-even point. However, below the break-even point, such companies are more limited in their ability to cut costs (since fixed costs generally cannot be cut as quickly or as easily as variable costs). Step-by-Step Online Course

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