What Are Variable Costs?
Variable costs are the direct costs a company incurs when producing goods or services. Variable costs are incurred in direct proportion to the quantity of goods or services produced.
Simply put: As a company’s production output increases, the variable costs increase. As output decreases, variable costs decrease.
Note: The term “variable” cost should not be confused with variable costing, which is an accounting method related to reporting variable costs.
We’ve included a video that explains variable costs, how to calculate them, and what they include.
How to Calculate Variable Costs
Variable costs are calculated by adding up the sum of all labor and materials required to produce one unit of anything that a company sells.
The Variable Cost Formula
Another useful calculation is to determine the average variable cost. To find the average variable cost, calculate the variable cost for all units then divide the sum by the number of units produced:
Total Variable Cost = Total Quantity of Output x Variable Cost Per Unit of Output
But what should you include in the variable cost per unit of output? It depends on what you’re producing and selling.
Variable Cost Per Unit of Output
A few items that may be included as part of the variable cost per unit of output may include:
- Direct materials costs
- Direct labor costs
- Transaction fees
- Billable costs
When looking over a list of potential costs to include in the variable cost per unit of output, a good rule of thumb is to consider whether the cost changes with the quantity of the output. If the answer is yes, it’s likely to be a variable cost. If the answer is no, it’s probably a fixed cost.
Variable Cost Example
Let’s take as an example Pierre’s French Bakery, which we used in our Operating Profit example. Pierre makes his baked goods from scratch. His shop is famous for its chocolate gateau (cake).
What ingredients does Pierre use for his cakes?
- Whole milk
- Vanilla beans
- Semi-sweet chocolate
- Heavy cream
Pierre also needs utilities such as electricity to run the mixer, water to wash the baking equipment, and natural gas to fire up the ovens. These are his variable costs.
Variable Costs vs. Fixed Costs
A bakery must have a mixer, ovens, and similar items to make any baked goods – not just cakes. So why not include the cost of the equipment, too? The cost of each piece of equipment remains the same regardless of how many cakes Pierre makes. Thus, the equipment in Pierre’s Bakery is considered a fixed cost.
Pierre adds up the total cost to make his chocolate cakes. For simplicity, we’ll assume that all of the costs, below, went into the batch. In actuality, Pierre might need to calculate what fraction of a pound of butter is used.
We’ll omit costs such as water, which is a utility bill as well as an ingredient. Pierre uses a great deal of water each month in his bakery to wash pans and utensils, and it is difficult to apportion the exact amount of water in the recipe from his overall water utility bill. It is an indirect cost because it cannot be tied to the production of one product (in this case, the cakes).
Determining Variable Costs
Pierre’s variable cost just to bake cakes might look like this.
The variable cost to make all of the cakes is $72. If Pierre’s recipe makes 6 dozen cakes (72 cakes), the variable cost per unit would be $1.
Variable cost/total quantity of output = x variable cost per unit of output
Variable cost per unit = = $72/72 = $1.
When Pierre puts his cakes in the shop window for sale, he knows he must mark up the cost per cake starting at $1. The $1 cost per unit covers only his variable costs, however. He must add the fixed costs per unit, calculated for his entire bakery on an annual basis, to the wholesale cake price. Because his accountant calculated this wholesale price last year, he knows that this figure is $0.32 cents per item.
By adding the fixed cost ($0.32) to the variable cost per unit ($1), Pierre would know the total cost per unit ($1.32). He would also know that he must sell each cake for more than $1.32 to achieve a profit.
Average Variable Cost
The average variable cost is used to help a company assess whether it will be profitable in the short-run. If marginal revenue, the revenue earned from selling the next unit, remains higher than the average variable cost, the company’s outlook is positive and should continue operations.
Companies calculate the average variable cost on both a per-item basis and over their entire production line. Once they know this number, companies can:
- Compare the cost of manufacturing a new product against the company’s average
- Assess the short-run profitability of the company (when taken into consideration with price)
Example of Average Variable Cost
Let’s say a new product has a variable cost of $4.45 per unit. If the company’s average variable cost over all of its products is $4.25, the new product’s variable cost is comparable to the average of the company’s other products. When the company adds up the variable and fixed costs of producing the new product – and marks up the wholesale production cost by its standard percent – the price of the new product should fit within their product line’s prices and meet their customers’ pricing expectations.
Instead, if it costs $7 to produce the new product, and the average variable cost for the company’s product line is $4.25. By the time the company adds up the fixed and variable costs to calculate the wholesale price – then marks up the wholesale price to determine the retail selling price – the new product may be priced too high for their customers’ taste.
Using Average Variable Cost
The company’s executives may decide that the new product just doesn’t fit into their product line because they must price it much higher than the other products. They can also seek new suppliers for the raw materials to make a product for lower costs. This would lower the variable cost and potentially put the production cost of the new product in line with their average production costs. They may also choose to go ahead and launch the new product at the higher price if they believe customer demand will outweigh price considerations.
As you can see, there’s rarely a one-size-fits-all answer. To determine whether a product should be produced, companies typically run many what-if scenarios and examine all factors including competition, market demand, pricing considerations, and their variable and fixed costs.
Average Variable Cost Formula
The average variable cost is calculated by taking a firm’s total variable costs, then dividing it by the total output.
The formula is:
To find the total variable cost, look at the variable costing income statement. Add the cost of goods sold (COGS) plus the variable selling, general, and administrative expense (SG & A), then divide it by the total output to find the average variable cost.
In the example of Pierre’s Bakery, the average variable cost includes all of the variable costs incurred by the bakery (e.g. ingredients, packaging, boxes, utilities) divided by the total output of baked goods. To find the average, Pierre must add up the variable costs and divide that sum by how many baked goods he created in a given period, then divide the costs by the quantity. The result is the average variable cost.
Fixed Cost vs Variable Cost
Fixed costs do not change with output. No matter how many widgets a factory produces, certain costs remain the same each period.
Pierre also has fixed costs each month: rent, insurance, equipment rental, etc. No matter how many cakes or macarons his bakery sells, the rent does not change nor does worker’s compensation or fire insurance.
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Are Variable Costs Always Relevant?
Variable costs are always relevant, but they may be much less relevant than other factors of production. They must be taken into consideration along with other factors when assessing whether or not to continue production of goods.
Are Variable Costs Operating Expenses?
No, they are different. Variable costs change with production output while operating expenses remain the same regardless of output.
To understand this concept, imagine a cloth factory. The factory owner’s operating expenses remain the same whether or not the factory produces bolts of cloth. The company must pay operating expenses (eg. mortgage/rent, insurance policy premiums, workers’ wages) regardless of whether the looms are weaving cloth or standing idle.
Variable costs increase as more cloth is produced and change with the type of cloth produced. Silk costs more to produce than cotton, and wool costs more to produce than synthetic cloth (like rayon or polyester). Material costs vary with the cost of raw materials used to produce them.
As the factory increases production, its variable costs increase while the operating expenses remain steady.
Can Variable Costs Be Indirect?
Yes, some variable costs can be indirect. At Pierre’s Bakery, the electricity to run the mixers and water used in recipes may be considered indirect costs. Everything Pierre produces uses both electricity and water. His bakery also uses both electricity to power the lights and cash register, and water is used in the restrooms. Because the costs of utilities can’t be applied to a specific product, they are considered indirect costs.
If costs can be applied directly to the production of a product, however, they are considered direct costs. Say that Pierre purchases a special chocolate to glaze the cakes, and the chocolate is only used in his cake production. That’s a direct cost.
Can Variable Costs Be Zero?
The only time variable costs can be zero is when the output is zero. To produce anything, a company must incur variable costs. In some industries, variable costs can trend towards zero, but rarely reach zero.
A cell phone company, for example, spends very little to transmit data once the towers are installed and customers join the service provider’s network. Their variable cost per customer is low and approaches zero, but there remains some variable cost. Each customer transmits and receives varying amounts of data (which requires electricity). If a customer uses her cell phone rarely, her variable cost may approach zero, but there is still a small cost to keep her on the network.
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