A corporate expense that varies with production output. Variable costs are those costs that vary depending on a company's production volume; they rise as production increases and fall as production decreases. Variable costs differ from fixed costs such as rent, advertising, insurance and office supplies, which tend to remain the same regardless of production output. Fixed costs and variable costs comprise total cost.
Variable costs can include direct material costs
or direct labor costs necessary to complete a certain project. For example, a
company may have variable costs associated with the packaging of one of its
products. As the company moves more of this product, the costs for packaging
will increase. Conversely, when fewer of these products are sold the costs for
packaging will consequently decrease. Variable costs are
corporate expenses that vary in direct proportion to the quantity of output.
Unlike fixed costs, which remain constant
regardless of output, variable costs are a direct function of production volume, rising whenever production
expands and falling whenever it contracts. Examples of common variable costs
include raw materials, packaging, and labor
directly involved in a company's manufacturing process.
The formula for calculating total variable cost
is:
Total Variable Cost = Total Quantity of
Output x Variable Cost Per Unit of Output
The term variable cost is not to be confused
with variable costing, which is an accounting method related to reporting
variable costs.
Let's assume XYZ Company has received an order
for 5,000 widgets for a total sales price of $5,000 and wants to
determine the gross profit that will
be generated by completing the order. First, the variable costs per widget must
be determined.
Let's assume the following:
Annual Widgets Produced: 100,000
Raw Materials Costs: $10,000
Direct Labor Costs: $50,000
From this information, we can conclude that each
widget costs 10 cents ($10,000 / 100,000 widgets) in raw materials and 50 cents ($50,000 /
100,000 widgets) in direct labor costs. Using the formula above, we can
calculate that XYZ Company's total variable cost on the order is:
5,000 x ($0.10 + $0.50) = $3,000
Therefore, the company can reasonably expect to
earn a $2,000 gross profit ($5,000 - $3,000) from the order.
While fixed costs, such
as rent or other overhead, generally remain level, variable
costs will correlate with the number of products
manufactured. Because average variable costs differ widely among industries,
comparisons are generally most meaningful among companies operating within the
same industry.
When analyzing a company's income statement, it should be
remembered that rising costs are not necessarily a troubling sign. Whenever sales rise, more units must first be
produced (excluding the impact of stronger pricing), which in turn means that
variable production costs must also increase. Thus, for revenues to climb, expenses must also
rise accordingly.
It is important, though, that revenues increase
at a faster rate than expenses. If, for example, a company reports volume growth of 8%, while cost of goods sold (COGS) only rises 5%
over the same span, then costs have likely declined on a per unit basis. If a company can find ways to
reduce the input costs associated with producing each item it sells, then its
profitability will improve. One way to monitor this
aspect of a company's business is to divide variable costs by total revenues to
figure costs as a percentage of sales.Variable costs frequently factor into profit
projections and the calculation of break-even points for a business or project.
Some costs change in a piecewise manner as output changes and therefore may not
remain constant per unit of output. Also, note that
many cost items have both fixed and variable components. For example,
management salaries typically do not vary with the number of units produced.
However, if production falls dramatically or reaches zero, then layoffs may occur. This is evidence that
all costs are variable in the long run.
A company with a large number of variable costs (compared
to fixed costs) may exhibit more consistent per-unit
costs and hence more predictable per-unit profit margins than a company with fewer
variable costs. However, a company with fewer variable costs (and hence a
larger number of fixed costs) may magnify potential
profits (and losses) because revenue increases (or
decreases) are applied to a more constant cost level. Part of being a successful
investor involves making an educated forecast about how a company will respond under different operating conditions, and one
of the key determinants is the proportion of fixed costs
to variable costs.