Variable Cost: What It Is and How to Calculate It

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02 DECEMBER, 2024

If you are a business owner, then the term “variable cost” must have been in your dictionary.

A variable cost is a business expense that fluctuates directly with production output. As production increases, variable costs rise, as production decreases, these costs fall. Read this blog to know more about variable cost because understanding what is variable cost is essential for businesses to maintain profitability and price their products effectively.

What Are Variable Costs?

Variable costs are expenses that change in proportion to the level of production or sales. Unlike fixed costs, which remain constant regardless of output, variable costs increase or decrease based on how much a company produces or sells.

Variable cost examples include raw materials, direct labour, and packaging. For example, if a company manufactures bicycles, the cost of the tyres, seats, and gears would be variable because the company needs more materials as production rises.

On the other hand, a company with fewer orders will incur lower variable costs as it requires fewer raw materials. Understanding what variable cost is crucial for companies that want to manage their budgets and adapt to production changes efficiently.

Types of Variable Costs

Variable costs can be classified into different categories depending on the nature of the business and the type of products or services offered. Here are the main types:-

Direct Materials: The raw materials required to create a product. For example, flour, sugar, and eggs would be considered direct materials in a bakery.
Direct Labour: Wages paid to employees who work directly producing goods. For example, a factory worker who assembles cars earns variable wages because they depend on the number of cars produced.
Commissions: Sales commissions paid to employees based on the number of products sold. If sales increase, the commission costs rise, making it a variable expense.
Production Supplies: These are smaller materials and tools used in the production process. For instance, cleaning supplies or machine oil used in a factory would be variable costs.
Shipping Costs: The costs incurred to ship products to customers also vary with the number of goods sold, making shipping costs a variable expense.

Each of these variable cost examples plays a critical role in business operations, and their accurate calculation is key to maintaining profitability.

How to Calculate Variable Costs in Manufacturing: A Step-by-Step

To calculate variable costs for a manufacturing company, follow these simple steps:-

Step 1: Identify variable costs
Start by listing all the costs that fluctuate with production, such as raw materials, direct labour, and production supplies.
Step 2: Determine cost per unit
Calculate the cost of producing one unit by dividing the total variable costs by the number of units produced.
Step 3: Multiply by the number of units produced
Multiply the cost per unit by the total number of units produced to get the total variable cost for that period.
Step 4: Adjust for production changes
As production increases or decreases, recalculate the total variable cost using the updated number of units produced.

Understanding how to calculate variable costs allows businesses to monitor and manage their expenses effectively.

Impact of Variable Costs on Business Strategy

Variable costs play a major role in shaping business strategies, especially for companies that experience fluctuating production levels. Here’s how:-

Helps in pricing strategies: Companies can price their products by accounting for the total cost per unit, including variable costs.
Affects profitability: Monitoring variable costs ensures that a company maintains profitability, especially during periods of low production.
Supports decision-making: Companies can decide whether to increase or decrease production based on how variable costs impact profit margins.

By understanding the variable cost meaning and managing these expenses, businesses can improve their financial health.

The Role of Variable Costs in Pricing Strategies

Variable costs directly influence how companies set their prices. Businesses need to consider both fixed and average variable costs to set prices that cover expenses and generate profit. Here’s how variable costs play a role in pricing:-

Cost-plus pricing: Companies calculate the total cost per unit, including variable costs, and then add a profit margin to determine the final price.
Break-even analysis: Companies determine the minimum price at which they must sell their products to cover both fixed and variable costs.
Discount strategies: Businesses can offer discounts during periods of high production, where variable costs per unit are lower.

Considering what is variable cost helps businesses design smart pricing strategies that balance costs and profitability.

Common Mistakes in Variable Cost Calculation and How to Avoid Them

Calculating variable costs can sometimes lead to errors. Here are common mistakes and tips to avoid them:-

Misidentifying fixed and variable costs
To avoid this, businesses should clearly distinguish between costs that fluctuate with production (variable) and those that remain constant (fixed).
Ignoring small variable costs
Include every variable cost, no matter how small. Failing to account for minor expenses can result in inaccurate calculations.
Overestimating or underestimating costs
Regularly review and update variable cost calculations to reflect current prices and production levels accurately.

Conclusion

Understanding variable cost meaning and how to calculate it is essential for businesses to manage their expenses and optimise profitability. By knowing the types of variable costs and their impact on pricing strategies, businesses can make informed decisions that benefit their bottom line. Proper management of variable costs ensures that companies remain financially healthy, especially during periods of fluctuating production.