Variable cost is one of the two major cost categories that you’ll find in nearly every business endeavor. Together with fixed costs, they form the foundation of all corporate expenses. Even in the top business schools we teach at, there is some confusion over what exactly is defined as a variable cost. Our goal is to provide an overview of these costs, how to calculate them, and what they are used for. By explaining the relationship between variable and fixed cost while providing real world examples, our hope is that you finish with a deeper understanding of how this lever is a powerful one to pull as a business owner or advisor.
Variable Cost Definition
Variable costs are the costs incurred to create or deliver each unit of output. So, by definition, they change according to the number of goods or services a business produces. If the company produces more, the cost increases proportionally. For example, Uber pays a driver for every ride they complete. This is a variable cost, and is Uber’s primary expense. It’s amazing how Uber has been able to convince Wall Street that it is primarily a fixed cost tech platform. It is in fact, a primarily variable-cost-based business, which has huge ramifications for how it can and should operate. But we digress.
Overall, variable costs are directly incurred from each unit of production, while fixed costs rise in a step function and are not based on each individual unit.
Variable Cost Formula
To calculate the total variable costs for a business you have to take into account all the labor and materials needed to produce one unit of a product or service. The total variable cost formula can then be described as the total quantity of output times the variable cost per unit of output. Be careful that you don’t mix up variable cost with variable costing, which is an accounting method used to report variable cost.
Average Variable Cost
The average variable cost can be considered as the total variable cost per unit of output. If you divide the total variable cost by the total output produced, then you receive the average variable cost [AVC]. Profit-maximizing manufacturing companies use the AVC to help them decide at which time they should end the production for a specific good. If the price they receive for the product is higher than the AVC, it is one indicator of a profitable product.
As an example of variable cost, let’s assume that SG was currently experiencing an economic recession. In this scenario, companies might expect that their variable costs would decrease on the back of reduced consumer demand.
This would mean that the company might need to cut jobs or buy in less of the materials that they use to make their products.
Alternatively, if there was currently a period of economic growth, companies might expect production to increase on the back of rising demand. As a result, a company would need to buy more materials and perhaps hire more workers to make their products. Because of this, variable costs would increase in line with an increase in demand.
A variable cost is an ongoing cost that changes in value according to factors like sales revenue and output. Variable costs include labor, raw materials and distribution costs. Businesses with high variable costs such as contract consulting work have lower margins than other companies but also lower break even points, according to Business Dictionary.
In this article, we’ll cover:
NOTE: FreshBooks Support team members are not certified income tax or accounting professionals and cannot provide advice in these areas, outside of supporting questions about FreshBooks. If you need income tax advice please contact an accountant in your area.
A variable cost is a recurring cost that changes in value according to the rise and fall of revenue and output level. Variable costs include credit card fees and shipping costs.
Small businesses with higher variable costs are not like those with high fixed costs—costs that don’t change with revenue and output, such as rent and insurance. Companies with high variable costs need to produce less to break even but they also have lower profit margins than companies with high fixed costs, according to Business Dictionary.
- For example, a company relies on materials and personnel to produce goods. If sales increase, the amount of materials and labor needed also increases. If sales decrease, resources and labor needed decreases as well.
Variable costs change based on how many goods are produced or services provided. The more variable costs, the lower the profit margin.
Industries with high fixed costs, like airlines, are less vulnerable to competition. They require huge amounts of investment in machinery and other physical items to start up.
Industries with high variable costs, like the service industry, that depends heavily on labor, are much more vulnerable to competition because there is less investment required to start up.
Total cost is the sum of total fixed costs and variable costs.
What Is a Variable Cost Example?
Variable costs include:
- Raw materials
- Commissions
- Piece rate labor [workers paid for each unit completed]
- Production supplies
- Billable staff labor
- Shipping costs
- Credit card fees
- Gas and mileage
- Specific project costs
Example #1
A business consultant has many variable costs because she does many different types of contracts that incur their own specific expenses. On one project, she has to pay for research. She also has to travel to visit the client and the cab fare is a variable expense. She pays an assistant hourly to help her and this billable labor is also a variable cost.
On another project, she needs to travel out of state and all her travel expenses are variable costs. She rents a temporary office to do her work. She buys new software to suit the particular project and she takes a course online to learn the new software. She has to borrow money to buy the new software and finance the training and the interest on that loan is a variable cost as well.
Example #2
An e-commerce business maintains a small warehouse and has to pay it’s hourly staff. Hours worked vary depending on the volume of orders. Shipping costs are a big variable cost for this business. The business has a salesperson who gets commission and a performance bonus.
Example #3
A pet sitting business has to travel to visit clients and the price of gas for the company vehicle is a variable cost, as is the number of miles traveled. Her business cell phone is pay-as-you-go and so is a variable expense. Her staff is paid based on the number of hours worked for clients and their billable hours is a variable expense as well.
Variable Cost Formula
The formula to calculate total variable cost is:
Total Variable Cost = Total Quantity of Output x Variable Cost Per Unit of Output
For example, a pet products company gets an order for 300 leashes for $300. To find variable cost per unit, we take the cost per unit in materials [25 cents] and direct labor costs [30 cents].
300 x [.25 + .30] = $165
Total variable costs would be $165, meaning gross profit would be $135 [$300 – $165].
People also ask:
Is Salary a Fixed or Variable Cost?
Salary is a fixed cost. Salaries do not vary based on production or revenue. They are a regular recurring expense and the amount paid out is set. That said, there may be variable costs on top of a salary. A commission, such as a percentage paid out for every unit sold on top of a salary, is a variable cost because it depends on output, according to Inc..
Is Labor a Variable Cost?
Salaries are not variable costs. They are fixed because they are paid out regularly and are independent of revenue level or production volume. But, other forms of labor are dependent on these factors, according to Accounting Tools.
Piece rate labor is one of these forms. Workers are paid based on every unit they make. Employees that are paid based on billable hours is another variable cost. This happens when a company bills a client for the hours its employees work—they only get paid based on the hours the company can bill.