What are Variable Costs?
Variable Costs are output-dependent and subject to fluctuations based on the production output, so there is a direct linkage between variable costs and production volume.
Table of Contents
How to Calculate Variable Costs
Variable costs, or “variable expenses”, are connected to a company’s production volume, i.e. the relationship between these costs and production output is directly linked.
Unlike fixed costs, these types of costs fluctuate depending on the production output (i.e. the volume) in a given period. Since costs of variable nature are output-dependent, the costs incurred increase (or decrease) given varying production volumes.
Variable costs are directly tied to a company’s production output, so the costs incurred fluctuate based on sales performance (and volume).
If product demand (and the coinciding production volume) exceed expectations — in response, the company’s variable costs would adjust in tandem.
- Increased Production Output → Greater Variable Costs
- Decreased Production Output → Reduced Variable Costs
As more incremental revenue is produced, the growth in the variable expenses can offset the monetary benefits from the increase in revenue (and place downward pressure on the company’s profit margins).
Variable Cost vs. Fixed Cost: What is the Difference?
The differences between variable costs vs. fixed costs are as follows:
- Variable Costs → The costs incurred that are directly tied to production volume and fluctuates based on the output in the given period.
- Fixed Costs → The costs incurred that remain the same regardless of production volume.
From the viewpoint of management, variable expenses are easier to adjust and are more in their control, while fixed costs must be paid regardless of production volume.
Fixed costs encompass a company’s obligations irrespective of the production output (e.g. rent, insurance premium) and occur periodically based on a pre-determined schedule, and are usually easier to predict and budget for.
In contrast, costs of variable nature are generally more difficult to predict, and there is usually more variance between the forecast and actual results. The amount incurred is directly tied to sales performance and customer demand, which are variables that can be impacted by “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 “variable” since the bonus is performance-based compensation and contingent on the company reaching certain targets thresholds on performance metrics such as:
- Share Price
- Revenue
- Profit Margin (%)
Variable Cost Formula
Since a company’s total costs (TC) equals the sum of its variable (VC) and fixed costs (FC), the simplest formula for calculating a company’s variable costs is as follows.
More specifically, a company’s variable costs are equal to the total cost of materials plus the total cost of labor:
Alternatively, a company’s variable costs can also be calculated by multiplying the cost per unit by the total number of units produced.
