Variable CostDefinition, Examples & Calculation

Written By:
Lisa Borga

What are Variable Costs?

Variable Costs are the expenses that change proportionally with the volume of goods or services which a company produces.

This simply means that variable costs are costs that change with the level of activity within a company.

As a company’s production of goods or services increases, so to will variable costs, and as production falls, so too will variable costs.

Some common examples of variable costs are the direct materials and labor used in production, utility expenses, and freight.

Variable costs contrast with fixed costs which do not change with products such as the cost of rent, insurance, or amortization.

Explaining Variable Costs

The total costs faced by any company are composed of the combined total of its variable costs and its fixed costs.

Variable costs consist of the costs a business faces that change with its level of production.

As a company’s production volume increases, its variable costs will increase by a proportional amount, and the opposite is also true should its production volume fall.

Because variable costs are directly related to the costs of producing a business’s goods or services, they can typically be changed relatively quickly.

As a result, they are generally regarded as short-term expenses.

How Can Variable Costs Be Calculated?

Variable costs can be calculated by multiplying the total quantity of output by the variable cost per unit of output.

This looks like this:

Total Variable Cost  =  Total Quantity of Output x Variable Cost Per Unit of Output

The Difference Between Variable and Fixed Costs

Variable and fixed costs are both critical concepts for businesses, and together they make up the total costs for a business.

Unlike variable costs, which are directly tied to the level of production of a business, fixed costs remain the same regardless of its production volume.

Common fixed cost examples include rent, property taxes, and depreciation.

For example, consider a toy manufacturer that rents a manufacturing space where it makes toys.

No matter the number of toys it makes, the rent will remain the same.

Even if the toymaker chooses to stop production altogether, rent would still be owed until the rental agreement ends.

Similarly, property taxes on the business’s assets will be owed regardless of how much the business produces, and its assets will gradually depreciate in value.

Because these costs are slow to change, though not impossible, they are regarded to be long-term.

Notably, sometimes experts include a third cost category in the mix known as mixed or semi-variable costs.

These costs will generally remain even if no production occurs and will often either be composed of both a fixed and variable component.

Alternatively, these semi-variable costs may remain fixed until a certain production volume is reached, after which it will become variable.

Typically, analysts look favorably upon companies that have a high ratio of variable to fixed costs.

This is because these costs exist in relation to the volume of production and therefore are closely related to a business’s sales success.

Variable Cost Examples

Let’s take a look at an example of variable cost using our toymaker once again.

Assume that every music box the toymaker crafts uses $20 in raw materials including string, wood, and metal plus $12 in indirect labor.

Here is a table showing how these costs change at different volumes of production.

As can be seen, when the toymaker does not produce any toys, there are no variable expenses.

However, as production increases, so do variable expenses.

Total cost is found by adding variable and fixed costs together.

The total cost can then be used to find a company’s profit which can be found by subtracting total cost from sales.

Profit = Total Sales – Total Cost

This means that a company’s profit is directly linked to its costs, and by reducing costs, profits can be increased.

Generally, when a business is looking for ways to reduce costs, they will focus on variable costs because these are more easily changed in the short term.

Although, fixed costs may have a significant impact on a business’s overall profit.

Let’s consider our toy manufacturer again and assume that music boxes are sold for a total of $50.

This means that the toymaker’s gross profit for each music box will be $18.

However, in order to determine the net profit, the company’s fixed costs must then be accounted for as well.

Let’s assume that the toy manufacturer has fixed costs of $1,000 every month, including its rent, insurance, utilities, and taxes.

Once fixed costs are accounted for, our toy manufacturer’s profit would appear like this in a given month.

A business loss occurs if fixed costs exceed a company’s gross profits.

Our toy manufacturer lost money on sales of 10 and 20 music boxes and only broke even when it reached 56 sales.

The break-even point occurs where fixed costs are equivalent to the gross margin, and the company neither makes a profit nor loses money.

When a company attempts to increase profit by reducing expenses, the first place it will look is at its variable costs, such as direct labor, raw materials, and freight.

Often these can be cut quickly and more effectively than fixed expenses.

However, it is important to ensure that any cuts made to these expenses do not negatively affect the quality of the service or product being offered.

Otherwise, sales volume could be negatively impacted.

By reducing variable costs, a business can make a direct impact on its contribution margin, which is the amount by which sales cost exceeds variable costs.

The contribution margin is a critical metric for companies because it determines the amount of profit that can be made from each sale of a product or service.

The formula for calculating the contribution margin follows:

Contribution Margin = Sales Revenue – Variable Costs

This can also be calculated as a ratio to provide a percentage value for easy reference.

This can be calculated as follows:

Contribution Margin Ratio = (Sales Revenue – Variable Costs) / Sales Revenue

For our toy manufacturer, the contribution margin is $18 found by taking the $50 sales price and subtracting the $32 in variable costs.

This could also be expressed as 36% found by taking the $50 and subtracting the $32 in variable costs, followed by dividing the resulting $18 by the $50 in sales revenue.

($50 – $32) / $50 = 36%

If the toy manufacturer were to reduce their variable costs by $7 to reach a new variable cost of $25, the contribution margin would correspondingly increase.

Its new contribution margin will be $25 found by taking its $50 sales revenue and subtracting its variable cost of $25.

By expressing it as a ratio, it is plain to see that the contribution margin has increased favorably by rising from the original 36% to a new contribution margin ratio of 50%.

($50 – $25) / $50 = 50%

This is highly beneficial for the toy manufacturer because as the contribution margin increases, so do profits.

By reducing variable costs by $7, the company now earns 14% higher gross profits off of every sale.

Common Types of Variable Costs

Some common examples of variable costs include raw materials, direct labor, packaging, freight, and utilities.

Often these costs are given on financial statements as the costs of goods sold.

How Are Fixed Costs Distinct From Variable Costs?

Variable costs are coldly associated with the costs of producing a company’s products.

In contrast, fixed costs are not variable with the costs of producing a good or service.

Variable costs are often provided as costs of goods sold on financial statements; but fixed costs are not included.

By cutting production volume, variable costs can be reduced, whereas fixed costs will still be charged regardless of production activity.

The Effect of Variable Costs on Growth and Profitability

When production volume increases, variable costs will as well.

It is possible for these costs to reach a level at which it exceeds the profit earned from sales, increasing production may be a poor choice.

In a situation such as this, a company would need to find the reason it is unable to attain economies of scale.

This type of situation is related to economies of scale which is the concept of how as production increases variable costs decrease proportionally to the total cost of production.

What Is the Difference Between Marginal and Variable Cost?

Marginal cost is the cost of making one more unit.

Though marginal costs do include variable costs, they also include fixed costs.

However, because fixed costs do not change as production increases, fixed costs will decrease as a percentage of total cost as production volume increases.

Key Takeaways

• Variable costs are those that change proportionally with the volume of production.
• When production rises, so do variable costs, and when production falls, so will variable costs.
• Unlike variable costs, fixed costs remain constant regardless of the level of production.