Variable Cost Explained in 200 Words & How to Calculate It

what is a variable cost

It is important to distinguish between the two types of costs. This helps make business decisions and determine how changes in the level of output affect costs. For instance, let’s say you make and sell hand-painted “World’s Best Boss” mugs. You might pay to package and ship your product by the unit, and therefore more or fewer shipped units will cause these costs to vary. Variable costs are usually viewed as short-term costs as they can be adjusted quickly.

  1. 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.
  2. If the price they receive for the product is higher than the AVC, it is one indicator of a profitable product.
  3. Average variable cost is often U-shaped when plotted graphically.
  4. Variable cost is one of the two major cost categories that you’ll find in nearly every business endeavor.
  5. For example, let’s say that Company ABC has a lease of $10,000 a month on its production facility and produces 1,000 mugs per month.
  6. That’s because these costs occur regularly and rarely change over time.

How to calculate variable cost per unit

Variable costs change based on the level of production, which means there is also a marginal cost in the total cost of production. Over a one-day horizon, a factory’s costs might largely consist of fixed costs, not variable. The company must pay for the building, the employee benefits, and the machinery regardless of whether anything is produced that day.

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You will need to charge more than that when you sell it because it costs 15 in variable expenses to produce. To make sure you are turning a profit on each item sold, you will also need to account for fixed costs. Examples of variable costs are sales commissions, direct labor costs, cost of raw materials used in production, and utility costs. 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. Your average variable cost uses your total variable cost to determine how much, on average, it costs to produce one unit of your product. For calculating average variable cost in the subtraction method, two other average costs must be known.

what is a variable cost

Variable expense examples

These expenses are directly related to a company’s level of production and may go up or down as a result of that level of production. There is also a category of costs that falls between fixed and variable costs, known as semi-variable costs (also known as semi-fixed costs or mixed costs). These are costs composed of a mixture of both fixed and variable components.

For the examples of these variable costs below, consider the manufacturing and distribution processes for a major athletic apparel producer. Hence, it is said to be directly proportional to the change in production volume. These costs are generally short-term and may be quickly adjusted. Once you’ve done everything you can to tighten up variable costs for your business, there are other ways to lower the cost of doing business. One important point to note about variable costs is that they differ between industries, so it’s not at all useful to compare the variable costs of a car manufacturer and an appliance manufacturer.

If these costs increase at a rate that exceeds the profits generated from new units produced, it may not make sense to expand. A company in such a case will need to evaluate why it cannot achieve economies of scale. In economies of scale, variable costs as a percentage of overall cost per unit decrease as the scale of production ramps up.

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. If your variable costs are $20 on a $200 item and your fixed costs account for $100, your total costs now account for 60% of the item’s sale value, leaving you with 40%. To find the average variable cost using the division method, two total numbers must be available. Total variable costs for a business are the costs that fluctuate in relation to total production over a specific time period.

Suppose Pentonic, a pen manufacturer wants to know whether their new line of pens would be profitable for them. They sell each pen at the price of Rs 10, while the total variable cost of 2000 pens is Rs 18,000 in total. Industries with a higher degree of variability will likely use more variable costs, like manufacturing and retail.

These can include parts, cloth, and even food ingredients required to make your final product.

Each component of a car is a variable cost, including the tires. For example, every car that is produced must have a set of four tires. If the tires cost $50 each, the tire costs for each manufactured car are $200. Because the manufacturer only pays this cost for each unit produced, this is a variable cost. There are many ways that a business can reduce its variable costs. For instance, increasing output using the same amount of material can dramatically cut down costs, provided the quality of goods isn’t impacted.

While a fixed cost remains the same over a relevant range, a variable cost usually changes with every incremental unit produced. A company can increase its profits by decreasing its total costs. Since fixed costs are more challenging to bring down (for example, reducing rent may entail the company moving to a cheaper location), 2 2 perpetual v. periodic inventory systems financial and managerial accounting most businesses seek to reduce their variable costs. Fixed costs remain the same regardless of whether goods or services are produced or not. As such, a company’s fixed costs don’t vary with the volume of production and are indirect, meaning they generally don’t apply to the production process—unlike variable costs.

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. The variable expense ratio calculates a company’s variable costs as a percentage of sales. Simply divide the total variable costs of the company by the total net sales of the company to determine the variable expense ratio.

For this reason, variable costs are a required item for companies trying to determine their break-even point. In addition, variable costs are necessary to determine sale targets for a specific profit target. The cost to package or ship a product will only occur if a certain activity is performed. Therefore, buyer entries under perpetual method financial accounting the cost of shipping a finished good varies (i.e. is variable) depending on the quantity of units shipped. Though there may be fixed cost components to shipping (i.e. an in-house mail distribution network with a personalized weighing and packaging product line), many of the ancillary costs are variable.

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