Variable costs: A comprehensive guide + variable cost formula

From purchasing raw materials to paying your employees, running a business involves keeping track of a wide range of expenses. When these expenses are related to the production of your goods or services, they are either fixed costs or variable costs.

Variable costs depend on output, meaning they can go up or down depending on business activities, such as how much your company sells or produces.

Need more clarification on what variable costs are and how they impact your business? Follow this comprehensive guide for a thorough explanation of variable costs, how they work, how to calculate them, and an example.

• How variable costs work
• How to calculate variable cost using the variable cost formula
• Variable cost example
• Additional variable cost considerations
• Variable costs FAQ

How variable costs work

Variable costs are expenses that change from month to month based on production. Depending on your company's output, variable costs may be higher or lower than before.

The higher your production output, the higher your variable costs will be for that period. On the other hand, the lower your production output, the lower your variable costs will be. While this may seem fairly straightforward, it can become confusing when dealing with them in real time.

Variable costs can be direct or indirect costs, meaning they can be directly related to the product itself or more generalized to the production process.

Some common examples of variable costs in a business include:

• Labor costs
• Raw materials
• Freight costs
• Machinery supplies
• Utilities
• Shipping option costs
• Credit card fees on purchases made by customers
• Sales commissions
• Advertising costs

Understanding your variable costs can help benefit your business, from helping you determine your pricing to make informed decisions that can help increase your profitability.

To help you better understand variable costs, let’s look at how it differs from other costs you may deal with.

Variable vs. fixed costs

The difference between variable and fixed costs is that fixed costs stay the same no matter how your production output changes. Examples of fixed costs include business insurance, rent, and employee salaries.

It is important to remember that fixed costs can still change over time. For example, your rent may increase in the future, but unlike variable costs, that change won't result from your production. If you need help tracking your business’s expenses and other transactions, you may want to consider using bookkeeping software.

Variable cost vs. marginal cost

Marginal cost represents the overall change in the total cost of production when a company increases its production by one unit. Unlike variable costs, marginal costs account for both fixed and variable costs. 

Whenever there is a change in the production cost, you'll have a marginal cost. Because of this, marginal costs exist whenever there are variable costs.

You can calculate marginal cost using the following formula: 

Marginal cost = change in cost ÷ change in quantity

For example, let’s say your current production allows you to produce 10 units for $2,000. After increasing your production, you’re able to produce 20 units for $3,000. In this case, your marginal cost would be $100 ($1,000 ÷ 10). 

Variable cost vs. average variable cost

While variable cost and average variable cost may seem the same, each cost means something completely different. The difference between variable and average variable costs is that the average variable cost represents a comparison of total variable costs to your output.

You can calculate average variable cost using the following formula: 

Average variable cost = total variable costs ÷ total output

For example, if your total variable cost is $10,000 and your output is 2,000 units, your average variable cost is $5.

Now that you’ve answered the question, “What are variable costs?” let’s take a look at how you can calculate them.

How to calculate variable cost using the variable cost formula

Now that you understand what variable costs are and how they differ from other costs you’ll encounter with your business, it’s time to learn how you can calculate them yourself.

Once you learn how to use the total variable cost formula, you can start calculating variable cost and use the information to help you make smart decisions. With this information, you can carefully evaluate:

• How profitable the good or service is
• Whether you should continue producing it
• Where you can make adjustments to reduce variable costs for that product or service
• How to price your goods or services

You can calculate total variable cost using the variable cost formula:

Total variable cost = variable cost per unit x output quantity

You can find the variable cost per unit using the formula for the average variable cost (Average variable cost = total variable costs ÷ total output).

For example, if your variable cost per unit is $5 and you’re producing 500 units, your total variable cost would be $2,500.

Variable cost example

To help you better understand how to calculate variable costs in the real world, let’s pretend that you are running a pizzeria. As the manager of the pizzeria, you know that it costs you $12 to make each pizza, with $2 going toward the ingredients and $10 going toward paying your employees for direct labor.

To help you get a better idea of the amount of time and cost required for labor, try using time tracking software. Below you will see how the variable costs change depending on the number of pizzas you make. As you make more and more pizzas, your variable costs increase. In addition, these variable costs fall to zero when you stop making pizzas.

When combining variable costs with fixed costs, you can calculate your total costs, which can help you determine your company’s profits, which are sales minus your total costs.

Now let’s say you sell each pizza for $16. For every pizza you sell, you’ll have a gross profit of $4. But if you want to determine your net profit, you’ll also have to subtract your fixed costs.

If your pizzeria has a monthly fixed cost total of $1,000 a month, here is what your monthly profits will look like depending on the number of pizzas you sell.

Whenever a business’s fixed costs are higher than its gross profits, it takes a loss. In the case of the pizzeria, they hit their break-even point when they sell 250 pizzas. After that, the business begins making profits.

If you’re looking to limit your variable costs to help boost your profits, you may need to cut down on variable expenses like the cost of ingredients or direct labor. But it's important that doing so doesn’t affect your product or service quality, as that could end up hurting your sales in the long run.

Additional variable cost considerations

When taking a deeper look at the types of variable costs you and your business encounter, here are some important considerations to keep in mind.

Relevant range

With variable costs, the relevant range is the range in which the cost of adding one more is the same as when adding the last. 

For example, let’s say you need to purchase flour for your business. For every pound of flour you purchase, you spend $3. But if you buy over 100 pounds of flour, your supplier discounts the price to $2.90 per pound. 

In this example, once you start buying more than 100 pounds of flour, you’re out of the relevant range as the price begins to change. Whenever you’re investigating your variable costs, be sure to keep the relevant range in mind.

Contribution margin

The contribution margin is your product’s selling price minus its variable cost per unit. This measurement is the money your company brings in after using sales to cover variable costs. If your product has a proportionately lower variable cost than its selling price, then it has a high contribution margin.

At first, every dollar of the contribution margin goes toward paying off fixed costs. After you account for the fixed costs, the leftover money is considered profit. Taking your contribution margin into account can help you understand how each product individually contributes to your overall profits.

Degree of operating leverage

Operating leverage measures a company’s combination of variable and fixed costs. If a company has a high amount of fixed costs and low variable costs, it is considered to have high operating leverage. On the other hand, a company with high variable costs and low fixed costs has low operating leverage.

If your company has high variable costs, increasing your sales will not significantly improve your profitability, as your variable costs will increase proportionally with your increased sales. If your business instead has low variable costs, your business will rely on a high sales volume to help boost your profitability and cover your high fixed costs.

Now that you’ve learned how variable costs can affect your business, you can move forward knowing how to better manage costs, predict cash outflow, and carefully plan the scalability of your business. And with accounting software, you can accurately track and record your variable costs through our automated system.

Variable costs FAQ

Are you still scratching your head about variable costs? Read through the answers to these commonly asked questions related to variable costs.

Are marginal costs fixed or variable costs? 

The marginal cost is the change in production cost by adding one more unit. Marginal cost only comes into play when variable costs are a factor in total production cost.

Marginal costs are not considered fixed costs because, with fixed costs, there is no change in the cost of production unit over unit. Even if you create more units during a period, your production costs will remain the same if only fixed costs are involved.

How do variable costs affect the marginal cost of production?

When variable costs increase, they cause the marginal cost of production to increase. As the marginal cost of production increases, your marginal returns diminish. 

Is salary a fixed or variable cost?

Salary is a fixed cost because the pay is the same every period, no matter how much the individual works.

Is labor a variable cost? 

In general, labor is a variable cost because the total expense for labor depends on how many hours employees have worked. For instance, in some months, an employee may work a standard 40 hours per week.

But in a busy month—say, during peak season—their hours may be significantly more. Similarly, in the offseason, their hours may be much lower. As such, labor is a variable cost that can easily increase or decrease the overall production cost.

That said, labor completed by salaried employees is a fixed cost because it is the same every pay period, regardless of hours worked. 

How do variable costs affect growth and profits? 

Generally speaking, a business with high variable costs compared to its fixed costs will usually have more consistent profits. This results from having a lower break-even point and reduced fixed costs.

What is another name for variable cost? 

Another name for variable cost is “unit-level cost” because it varies on the number of units your business produces. 

Why is variable cost analysis important? 

Analyzing your variable costs is important because it can help you understand your company’s profitability and inform your business decisions, whether you’re looking to change the prices of your goods and services or purchase your raw materials from a new supplier.