Variable Cost

What Is a Variable Cost?

A variable cost is a corporate expense that changes in proportion to how much a company produces or sells. Variable costs increase or decrease depending on a company’s production or sales volume—they rise as production increases and fall as production decreases.

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. A variable cost can be contrasted with a fixed cost.

Key Takeaways

  • A variable cost is an expense that changes in proportion to production output or sales.
  • When production or sales increase, variable costs increase; when production or sales decrease, variable costs decrease.
  • Variable costs stand in contrast to fixed costs, which do not change in proportion to production or sales volume.

Understanding Variable Costs

The total expenses incurred by any business consist of variable and fixed costs. Variable costs are dependent on production output or sales. The variable cost of production is a constant amount per unit produced. As the volume of production and output increases, variable costs will also increase. Conversely, when fewer products are produced, the variable costs associated with production will consequently decrease.

Examples of variable costs are sales commissions, direct labor costs, cost of raw materials used in production, and utility costs.

Variable costs are usually viewed as short-term costs as they can be adjusted quickly.

How to Calculate Variable Costs

The total variable cost is simply the quantity of output multiplied by the variable cost per unit of output:

Total Variable Cost  =  Total Quantity of Output X Variable Cost Per Unit of Output

Variable Costs vs. Fixed Costs

Fixed costs are expenses that remain the same regardless of production output. Whether a firm makes sales or not, it must pay its fixed costs, as these costs are independent of output.

Examples of fixed costs are rent, employee salaries, insurance, and office supplies. A company must still pay its rent for the space it occupies to run its business operations irrespective of the volume of products manufactured and sold. If a business increased production or decreased production, rent will stay exactly the same. Although fixed costs can change over a period of time, the change will not be related to production, and as such, fixed costs are viewed as long-term costs.

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. If no production occurs, a fixed cost is often still incurred.

In general, companies with a high proportion of variable costs relative to fixed costs are considered to be less volatile, as their profits are more dependent on the success of their sales.

Example of a Variable Cost

Let’s assume that it costs a bakery $15 to make a cake—$5 for raw materials such as sugar, milk, and flour, and $10 for the direct labor involved in making one cake. The table below shows how the variable costs change as the number of cakes baked vary.

No of Cakes Cost of sugar, flour, butter, and milk Direct Labor
Total variable cost
1 cake $5 $10 $15
2 cakes $10 $20 $30
7 cakes $35 $70 $105
10 cakes $50 $100 $150
0cakes $0 $0 $0

As the production output of cakes increases, the bakery’s variable costs also increase. When the bakery does not bake any cake, its variable costs drop to zero.

Fixed costs and variable costs comprise the total cost. Total cost is a determinant of a company’s profits, which is calculated as:

Profits = S a l e s − T o t a l   C o s t s \begin{aligned} &\text{Profits} = Sales – Total~Costs\\ \end{aligned}​Profits=Sales−Total Costs​

A company can increase its profits by decreasing its total costs. 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. Decreasing costs usually means decreasing variable costs.

If the bakery sells each cake for $35, its gross profit per cake will be $35 – $15 = $20. To calculate the net profit, the fixed costs have to be subtracted from the gross profit. Assuming the bakery incurs monthly fixed costs of $900, which includes utilities, rent, and insurance, its monthly profit will look like this:

Number Sold Total Variable Cost Total Fixed Cost Total Cost Sales Profit 20 Cakes $300 $900 $1,200 $700 $(500) 45 Cakes $675 $900 $1,575 $1,575 $0 50 Cakes $750 $900 $1,650 $1,750 $100 100 Cakes $1,500 $900 $2,400 $3,500 $1,100

A business incurs a loss when fixed costs are higher than gross profits. In the bakery’s case, it has gross profits of $700 – $300 = $400 when it sells only 20 cakes a month. Since its fixed cost of $900 is higher than $400, it would lose $500 in sales. The break-even point occurs when fixed costs equal the gross margin, resulting in no profits or loss. In this case, when the bakery sells 45 cakes for total variable costs of $675, it breaks even.

A company that seeks to increase its profit by decreasing variable costs may need to cut down on fluctuating costs for raw materials, direct labor, and advertising. However, the cost cut should not affect product or service quality as this would have an adverse effect on sales. By reducing its variable costs, a business increases its gross profit margin or contribution margin.

The contribution margin allows management to determine how much revenue and profit can be earned from each unit of product sold. The contribution margin is calculated as:

Contribution Margin = G r o s s   P r o f i t S a l e s = ( S a l e s − V C ) S a l e s where: V C = Variable Costs \begin{aligned} &\text{Contribution~Margin} = \dfrac{Gross~Profit}{Sales}=\dfrac{ (Sales-VC)}{Sales}\\&\textbf{where:}\\&VC = \text{Variable Costs}\\ \end{aligned}​Contribution Margin=SalesGross Profit​=Sales(Sales−VC)​where:VC=Variable Costs​

The contribution margin for the bakery is ($35 – $15) / $35 = 0.5714, or 57.14%. If the bakery reduces its variable costs to $10, its contribution margin will increase to ($35 – $10) / $35 = 71.43%. Profits increase when the contribution margin increases. If the bakery reduces its variable cost by $5, it would earn $0.71 for every one dollar in sales.

What Are Some Examples of Variable Costs?

Common examples of variable costs include costs of goods sold (COGS), raw materials and inputs to production, packaging, wages, and commissions, and certain utilities (for example, electricity or gas that increases with production capacity).

How Do Fixed Costs Differ From Variable Costs?

Variable costs are directly related to the cost of production of goods or services, while fixed costs do not vary with the level of production. Variable costs are commonly designated as COGS, whereas fixed costs are not usually included in COGS. Fluctuations in sales and production levels can affect variable costs if factors such as sales commissions are included in per-unit production costs. Meanwhile, fixed costs must still be paid even if production slows down significantly.

How Can Variable Costs Impact Growth and Profitability?

If companies ramp up production to meet demand, their variable costs will increase as well. If these costs increase at a rate that exceeds the profits generated from new units produced, it may not make sense to expand. A company in such a case will need to evaluate why it cannot achieve economies of scale. In economies of scale, variable costs as a percentage of overall cost per unit decrease as the scale of production ramps up.

Is Marginal Cost the Same as Variable Cost?

No. Marginal cost refers to how much it costs to produce one additional unit. The marginal cost will take into account the total cost of production, including both fixed and variable costs. Since fixed costs are static, however, the weight of fixed costs will decline as production scales up.