# Variable Cost Definition, Factors, Formula, and Applications

Fixed costs are normally independent of a company’s specific business activities. Variable costs increase as production rises and decrease as production falls. Understanding the difference between these costs can help a company ensure its fiscal solvency. Alternatively, suppose a company opts to rent the machinery on a per-unit basis. When you process credit cards and debit cards in your business, you pay a fee for credit card processing services.

The cost of insuring the factory building is a fixed cost when the independent variable is the number of units produced within the factory. In other words, the factory’s property insurance might be \$6,000 per year whether its output is 2 million units, 3 million units, or 5 million units. On the other hand, if the independent variable is the replacement cost of the factory buildings, the insurance cost will be a variable cost. To determine the total variable cost, simply multiply the cost per unit with the number of units produced. Determining what constitutes a direct variable cost can sometimes be challenging.

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. Watch this short video to quickly understand the main concepts covered in this guide, including what variable costs are, the common types of variable costs, the formula, and break-even analysis. Below is an extract from a budgeting exercise in our Finance for the Non-Finance xeros growth strategy Manager. You can see the VC per unit in Column E. For budgeting profit, we just estimate the Sales volume (2000 units) and put the (shown) formula against each variable cost input. Commissions are often a percentage of a sale’s proceeds that are awarded to a company as additional compensation. Because commissions rise and fall in line with whatever underlying qualification the salesperson must hit, the expense varies (i.e. is variable) with different activity levels.

Understanding variable costs and their impact on profitability is critical for aspiring business owners. As illustrated previously, focusing on variable costs instead of fixed costs results in a lower break-even point. This makes it easier for a business to attain profitability, as it does not need to produce as many goods to meet its sum of fixed and variable costs. Because variable costs scale alongside, every unit of output will theoretically have the same amount of variable costs. Therefore, total variable costs can be calculated by multiplying the total quantity of output by the unit variable cost.

## Lean Management Techniques

Graphically, we can see that fixed costs are not related to the volume of automobiles produced by the company. As the production output of cakes increases, the bakery’s variable costs also increase. Examples of fixed costs are rent, employee salaries, insurance, and office supplies.

After reaching a certain production level, the benefits might diminish, and variable costs may not decrease at the same rate. This can fluctuate based on various factors such as the price of raw materials or changes in labor costs. The more fixed costs a company has, the more revenue a company needs to generate to be able to break even, which means it needs to work harder to produce and sell its products. That’s because as the number of sales increases, so too does the variable costs it incurs.

For instance, increasing output using the same amount of material can dramatically cut down costs, provided the quality of goods isn’t impacted. For example, if workers need to work overtime when a business increases production, the business may have to pay an overtime premium on top of the worker’s standard wage rate. Along the manufacturing process, there are specific items that are usually variable costs. For the examples of these variable costs below, consider the manufacturing and distribution processes for a major athletic apparel producer.

## Example 1 – Fixed vs. Variable Costs

Because Variable Costs are tied to production, they are usually thought of as a constant amount expensed per unit produced. She’s been creating and promoting content for over 4 years, covering a range of topics in the payment processing industry. Brontë is currently the Director of Marketing at PaymentCloud, a merchant services provider that offers business solutions for companies in all industries – no matter the risk. All of this means increasing leverage by focusing on overhead costs has the potential to yield large returns for a business.

1. The most common examples of fixed costs include lease and rent payments, property tax, certain salaries, insurance, depreciation, and interest payments.
2. This is because insurance should remain constant, regardless of whether you increase production.
3. Since fixed costs are more challenging to bring down (for example, reducing rent may entail the company moving to a cheaper location), most businesses seek to reduce their variable costs.
4. Refining and optimizing production processes can lead to reduced waste, faster production times, and ultimately, lower variable costs.
5. This decision should be made with volume capacity and volatility in mind as trade-offs occur at different levels of production.

Though this cost structure protects a company in the event the demand for their goods decreases, it limits the upside profit potential the company could have received with a more fixed-cost-focused strategy. For businesses, setting the right price for products or services is a balancing act. This is the idea that every unit bought and sold adds Revenue and (variable) costs to the P&L.

## Variable Costs

Many credit card processors offer a per-transaction commission structure, meaning instead of paying a monthly access fee, you pay a commission on each charge. Managing these factors diligently allows companies to boost margins by reducing variable cost per unit. Classifying costs as either variable or fixed is important for companies because by doing so, companies can assemble a financial statement called the Statement/Schedule of Cost of Goods Manufactured (COGM). This is a schedule that is used to calculate the cost of producing the company’s products for a set period of time. 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.

## Video Explanation of Costs

Variable costs can guide businesses in determining how to allocate resources optimally. An increase in the number of deliveries being made will increase the expense of gasoline, but not the cost of the insurance, depreciation, or loans. For example, if a spike in demand for a particular raw material occurs due to global shortages, the cost to purchase that material will increase. Therefore, for Amy to https://www.online-accounting.net/online-store-accounting-10-best-accounting/ break even, she would need to sell at least 340 cakes a month. Understanding the nuances and applications of each cost type in various scenarios enables comprehensive cost management and optimal financial planning. For information pertaining to the registration status of 11 Financial, please contact the state securities regulators for those states in which 11 Financial maintains a registration filing.

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. Costs are fixed for a set level of production or consumption and become variable after this production level is exceeded. Examples of variable costs include a manufacturing company’s costs of raw materials and packaging—or a retail company’s credit card transaction fees or shipping expenses, which rise or fall with sales.

Mastering the analysis of how costs behave enables companies to make astute decisions around budgeting, pricing, production levels, and elevating efficiency, thereby driving business sustainability and growth. This decision should be made with volume capacity and volatility in mind as trade-offs occur at different levels of production. High volumes with low volatility favor machine investment, while low volumes and high volatility favor the use of variable labor costs. In the second illustration, costs are fixed and do not change with the number of units produced.

Variable costs are any expenses that change based on how much a company produces and sells, such as labor, utility expenses, commissions, and raw materials. Understanding variable costs makes it easier to price your products correctly. Many businesses use the “Variable Cost-Plus Pricing” strategy, which involves adding a markup to variable costs to determine the price of a product. This pricing strategy assumes the markup will also cover the fixed costs.