What Is Variable Cost?
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 Variable Cost Is Calculated
Variable costs are calculated by adding up all of the labor and materials required to produce one unit of anything sold by a company.
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
When looking over a list of potential costs to include in the variable cost per unit of output, consider whether the cost changes with the quantity of the output. If so, it’s likely to be a variable cost. If not, it’s probably a fixed cost.
Variable Cost Example
Pierre’s French Bakery (which we used in our operating profit example) makes baked goods from scratch. The shop is famous for its chocolate gateau (cake).
To produce their cakes, they need the following ingredients:
Pierre's 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 the variable costs.
The Difference Between Variable Cost and Fixed Cost
Pierre’s Bakery must have a mixer, ovens, and other similar items to produce baked goods. You can’t include the cost of the equipment because it remains the same, no matter how many cakes Pierre makes. In other words, fixed costs do not change with output.
Other monthly fixed costs might include rent, fire insurance, and equipment rental.
How to Determine Variable Costs
Pierre adds up the total cost to make his chocolate cakes. Let's assume that all of the costs (listed below) went into each batch. In actuality, Pierre might need to calculate what fraction of a pound of butter is used.
Pierre uses a great deal of water each month in his bakery to wash pans and utensils. It is difficult to deduct the exact amount used in recipes from his overall water utility bill. Therefore, we’ll omit costs (such as water) because it is an indirect cost and cannot be tied to the production of one single product.
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.
What Is 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
Imagine that a new product has a variable cost of $4.45 per unit. If the company’s average variable cost for 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.
Now imagine that 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.
How to Use Average Variable Cost
A company may decide that the new product just doesn’t fit into their product line because it needs to be priced 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
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.