Understanding the different expenses your business needs to account for is essential for proper financial management. Expenses related to the production of your goods or services are categorized as either fixed or variable costs. Variable costs depend on output, meaning they can go up or down depending on business activities.
Need more clarification on what variable costs are and how they impact your business? Use this guide for a thorough explanation of variable costs, examples, and how to calculate them. If you’re looking for specific information related to variable costs, use the links below to navigate the post.
- What is a variable cost?
- How to calculate variable costs
- Variable costs and your bottom line
- Variable costs: Frequently asked questions
A variable cost is an expense that changes from month to month based on production. Depending on the level of output, variable costs may be more or less than they have been previously.
The higher your production output, the higher your variable costs for that period. The lower your production output, the lower your variable costs will be for that period. It seems fairly straightforward, but it can get confusing when you’re 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 variable costs include:
- Labor costs
- Raw materials
- Machinery supplies
- Shipping costs
- Credit card fees on purchases made by customers
- Sales commissions
There are two main types of costs: variable and fixed.
A business’s fixed costs are those that remain the same despite the level of output for that month. Fixed costs are those that are incurred on a consistent basis regardless of business activities. This means that no matter how little you sell or produce that month, you’ll need to pay the same fixed expenses.
When trying to manipulate your expenses—for instance, trying to stay within budget or increase profit margins—variable costs are typically easier to reduce. This is because variable costs usually have more alternatives you can turn to, such as switching suppliers or increasing efficiencies. However, when cutting variable expenses, it’s essential that you avoid decreasing the quality of your product or service as a result.
Some common fixed costs include:
- Office space rent
- Loan payments
- Machinery rental
- Depreciation of assets
In addition to fixed and variable costs, there are also mixed costs—also known as semi-variable costs. Mixed costs are those that remain stable, or fixed, up to a certain number of units. Once that production volume is surpassed, the cost is based on each additional unit.
This can also apply to expenses that are partially fixed and partially variable. For example, paying for an employee who has a base salary but can also earn commission would be a mixed cost. Their salary is considered a fixed cost, but any commission paid is a variable cost because it’s based on units or dollar amount sold.
Now that you have a better understanding of what variable costs are, let’s take a look at some real-world examples to provide more context. Different types of businesses will incur and be impacted by variable expenses, as shown in the examples below.
- Example 1: In a retail setting, prominent variable costs include sales commissions and checkout supplies like bags. These expenses will go up and down each period depending on sales volume.
- Example 2: You run a small online jewelry business, and suddenly one of your products gains momentum. This doubles or triples the number of orders in the span of a month. You are going to need more materials—chains, beads, whatever it may be—to fulfill all the new orders. Your variable expenses for that period will be much higher because the amount of materials used, and in turn the total cost of your materials, increased.
- Example 3: Let’s say you run a bakery. During the busy season, your variable costs of materials are going to be much higher. For example, during the holidays you will likely need more eggs, flour, and other ingredients on hand to meet demand for baked goods at your shop. However, post-holiday season, you will likely see a decrease in business, meaning you’ll spend less on variable costs like raw materials.
Consider how similar circumstances would play out based on your operations.
Being able to calculate the variable costs in total and for a specific product or service is important when making financial 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 products or services
Variable costs are calculated by taking the cost per unit of output and multiplying it by the output quantity.
Total variable cost = cost per unit x output quantity
To find the variable cost per unit, you need to use the formula for average variable cost:
Average variable cost = total variable cost ÷ output
Calculating total variable costs also allows you to perform a break-even analysis. Break-even analysis allows you to determine the product volume you must sell to cover the costs of making your product. To find the break-even point, you’ll need the following equations:
Break-even point = fixed costs ÷ (revenue per unit – variable cost per unit)
Based on sales dollars
Break-even point = fixed costs ÷ contribution margin
Contribution margin = product price – variable costs
Break-even analysis is an important tool in evaluating the stability of your business and whether your current pricing is high enough to offset costs.
It’s important to have an in-depth understanding of variable costs because they can significantly impact your company’s bottom line as you grow. How so? Well, when you increase production to meet growing demand from your customers, your production costs will naturally increase. More specifically, variable costs, those that increase per unit of production, will increase significantly.
Not only that, but you have to think of variable costs to the increased sales of said products and services if you pay out commissions. The more units your salespeople sell, the more you’ll owe them that month for commission. Consider that one of your salespeople makes a large sale, bringing on a new client. For that month—and similar months—you will have considerably higher variable costs.
Having an understanding of your variable costs and how you can manipulate them can help you scale and preserve profitability. Mastering this skill will make it much easier to stay in the black.
Are marginal costs fixed or variable costs?
The marginal cost is the change of 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 marginal cost of production increases, your marginal returns diminish.
Is salary a fixed or variable cost?
Salary is considered a fixed cost because pay is the same every period, no matter how much the individual works.
How are direct costs and variable costs different?
Direct costs can be tied to a product, while variable costs are tied to the number of units produced. Some variable costs can be classified as direct costs, but many direct costs are fixed. For example, direct materials and direct labor are both variable costs because they fluctuate based on production levels.
Is labor a variable cost?
In general, labor is categorized as a variable cost because the total expense for labor depends on how many hours have been 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 off-season, their hours may be much lower. As such, labor is a variable cost that can easily increase or decrease the overall cost of production.
That said, labor completed by salaried employees is a fixed cost because it is the same every pay period, regardless of hours worked.
Moving forward, you will be able to better manage costs, predict cash outflow, and carefully plan scalability of your business. And with QuickBooks Online accounting software, you can accurately track and record your variable costs through our automated system. Not only that, but you’ll have access to customized reports that provide valuable insights into your business’s expenses and cash flow. These powerful tools can empower you to make important business decisions that drive you toward your goals for growth.
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