What Is Variable Cost?
If you're a small business owner, you undoubtedly want to keep a close eye on your finances. Small businesses don't have the same monetary buffers as large corporations, so every penny really counts. Up-to-date, accurate accounting will allow you to track cash inflow and outflow and monitor where you're gaining - or losing - money. This information will then allow you to streamline your finances, cutting losses and ultimately boosting the bottom line.
Variable cost is one factor you want to keep in mind. This refers to a type of expense that fluctuates in proportion to your business's production output. So, if you are producing a lot of goods, variable costs increase. If you aren't producing a lot of goods, variable costs decrease. Examples might include the cost of raw materials needed to produce your goods or the packaging you use to ship finished products to customers.
The below guide provides greater detail on what variable cost is, demonstrates how to calculate it, and explains how tracking variable costs benefits you as a business owner.
What Is Variable Cost?
A variable cost is a type of ongoing expense that fluctuates in value depending on your production output. Types of variable costs might include raw materials, packaging, direct labor, sales commissions, utility costs, and distribution expenses.
Variable costs tend to also run in direct proportion to demand and sales volume: If there is a great demand for your product, you will logically produce more (meaning higher variable costs) and then sell more. In this way, variable costs can also be an indicator (among many) of your business's success.
Variable Cost vs. Fixed Cost
Variable costs are defined as opposite fixed costs. Fixed costs are expenses that don't change in relation to production levels or sales revenue. Examples might include commercial property rent and business insurance. Differentiating between fixed and variable business expenses in your small business accounting can help inform smart decision-making.
Here's an example:
Say you run a sandwich shop. You find that the money it takes you to run the shop (e.g., pay rent, labor, utilities) is more than the money you are making with the shop. You took out a one-year lease on your commercial business space. You opened your shop in January. Now, it's June, and you are trying to figure out if it's worth staying open.
Your monthly revenue totals $2,500, but your monthly losses total $3,000, meaning you're minus $500 every month. If you maintain operations as is, you'll end up with a loss of $500 per month over six months (July to August), resulting in an overall loss of $3,000 by the time the year ends and your commercial lease is up.
But what happens if you close down now?
To figure it out, you make a breakdown of your fixed expenses versus variable expenses every month. Let's say in a single month, your fixed versus variable costs broke down like this:
- Fixed costs: $1,400
- Rent: $700
- Utilities: $100
- Worker salaries: $600
- Variable costs: $1,600
- Sandwich supplies (bread, meats, vegetables): $1,000
- Total labor costs: $600
You now know that your variable costs exceed your fixed costs. If you cease operating, you'll still have to pay the fixed costs of $1,400 per month regardless. You have six months left on your commercial lease. So, you will lose $8,400 after six months.
However, if you stay open, you will continue to lose just $500 per month - so, you will lose $3,000 after six months. (Remember: You are making money every month, with monthly revenue of $2,500. The problem is just that your fixed and variable costs add up to $3,000, so you aren't turning an actual profit).
With this information, you decide to stay open. You also look for ways to cut those variable costs and see if you can make your sandwich shop profitable. Instead of the expensive artisanal parmesan you've been splurging on, for example, you might go for something cheaper.
Examples of Variable Costs
We mentioned a few possible types of variable costs above. Here's a more detailed breakdown of what might be considered a variable cost when looking at your business operating expenses:
- Materials used for production, notably physical goods like cloth, parts, food, and more
- Equipment used for production, including automation equipment and software
- Wages for staff, which will likely increase the more products you make
- Sales commissions paid to salespersons
- Credit card fees and online payment platform fees incurred from customer transactions made via card or platforms like PayPal
- Packaging and shipping costs paid to get products to customers
Breaking down an example of a variable cost in action can clarify how this cost changes with production volume.
Let's take the sandwich shop example above. Say you have your signature sandwich, the Big Faux Turkey Deluxe (a vegetarian sandwich made with imitation turkey breast). Each sandwich requires $3 of raw material to make, including bread, faux turkey, and the standard fixings (lettuce, tomato, and mayo). Then, there's direct labor to account for.
Here's how variable costs change depending on the number of sandwiches your business produces:
|1 Sandwich||5 Sandwiches||10 Sandwiches|
|Cost of materials||$3||$15||$30|
|Direct labor costs||$5||$25||$50|
|Total variable costs||$8||$40||$80|
As output increases, variable costs rise. Your fixed costs and variable costs combined equal the total cost. This can help to determine your business profits. Here's the formula:
|− Total Costs|
So, if you sell a Big Faux Turkey Deluxe with pricing starting at $8, you will just break even. However, if you can reduce your total costs (by reducing fixed and/or variable costs), you'll be able to turn a profit.
What Is the Formula for Variable Cost?
So, how can you know your business's variable cost? First, note that there are two types of variable cost to calculate: total variable cost and average variable cost.
Your total variable cost is the sum of all variable costs that go into producing each product you sell. To calculate the variable cost for each product, multiply the number of units produced by the variable cost of a single unit. Here's the formula:
|Total Quantity of Output|
|× Variable Cost per Unit of Output|
|= Total Variable Cost|
Say you sell branded T-shirts and baseball caps. Including all variable costs (materials, labor, packaging, shipping, and payment fees), it takes $10 to make one T-shirt and $15 to make one baseball cap. Let's say you have sold 10 T-shirts and 10 baseball caps:
|10 T-shirts produced||x||$10 variable costs per T-shirt||=||$100 total variable costs for T-shirts|
|10 caps produced||x||$15 variable costs per cap||=||$150 total variable costs for caps|
|=||$250 total variable costs|
Then, there's your average variable cost. This is calculated by dividing your total variable cost by the number of units produced. Here's the formula:
|Average Variable Cost|
So, in the example above, you'd divide $250 by 20 to get $12.50.
Why Is Variable Cost Important?
Variable costs are essential if you want to conduct a break-even analysis of your business. If a company has high variable costs, it generally doesn't need to produce as much to break even. We alluded to this briefly above with our sandwich example (the Big Faux Turkey Deluxe).
A break-even analysis determines how much revenue you need — or, in this case, how many units (sandwiches) you need to sell — to cover your total costs. Here's the break-even formula:
|Break-Even Point (in Units)|
Knowing your break-even point can help inform your business planning. Once you know how many units you need to sell to break even, you can ramp up your marketing, for example. Alternatively, you might look at ways to lower the break-even point by bringing down the total costs needed for production. Generally, if you can reduce variable costs, your gross profit margin should increase.
Skynova Is Here to Help Answer Your Small Business Questions
Understanding variable costs can guide smart business decision-making. To accurately calculate variable costs, you have to track and record expenses. Skynova's accounting software for small businesses can help you organize and manage your finances. Skynova further offers a diversity of other products, including business templates and more.
Discover how Skynova's software can help support your small business's profitability.
Notice to the Reader
The content within this article is meant to be used as general information about variable cost and may not apply to your specific situation. Always consult with a professional accountant to ensure you're meeting accounting standards.