Understanding the concept of variable costs incurred by a company and the ability to calculate them is vital to anyone having ties with a business. Managing costs and budgeting is one of the most critical tasks in a business. To generate profit, one will simultaneously create costs, which can be particularly significant for small firms and start-ups that do not yet enjoy the benefits of economies of scale. Due to that reason, individuals learn how to classify costs, calculate profit margins, and create financial statements. This information helps companies make informed decisions, plan for the future and develop cost forecasts to stay profitable.
If you would like to be able to do the same, you have come to the right place. This article will help you gain an in-depth understanding of variable costs and how to calculate them. It will provide you with the fundamental knowledge you can build upon later.
What are Variable costs
Any economic transaction or production process generates costs. One can divide such costs into two groups based on their response to the activity level. Fixed costs are constant and remain the same, independent of the production process. Variable costs, on the other hand, change according to the production rate. These two costs combined make up the total expenses. Some examples of variable costs are:
- Direct labor– All the wages and benefits paid to the workers and employees directly involved in the manufacturing process of a product (Example: workers in an assembly line, Kitchen staff in a restaurant).
- Direct Materials– Direct materials are raw materials and supplies that are an integral part of the finished product and are used in manufacturing.
- Sales Commission– sales commissions are usually a percentage of the total sales an employee has made, paid to them on top of their fixed salary. Since this cost varies based on the number of sales a person makes, it is considered a variable cost.
- Shipping & transportation costs – Most shipping, packaging, and transportation costs are charged per unit of a good.
Definition and Calculation
To summarize in one sentence, variable costs are expenses that change in proportion to the production volume of goods or the number of services provided. They increase if there is a rise in the level of activity and equal to zero if there is no production at all.
To calculate the total amount of variable costs incurred, one will need to multiply the final output produced by the variable cost per unit of output.
Total variable cost = Quantity of output x Variable cost per unit of output
There is also another way to determine the total variable costs, which would be to subtract total fixed costs from the total costs.
Total variable costs = Total costs – Total fixed costs
The formulas given above will be clearer with examples.
Example 1
“Buns and Roses” is a new bakery that opened in 2019. Due to its small size, the owner cannot afford to rent a space for the bakery and the cakes are provided only with a delivery option. Due to gaining popularity, the owner is considering expanding the business. However, to be on the safe side, they first want to calculate their costs.
There are two bakers employed- each of whom gets paid $7 per cake they make. The cost of ingredients used for one cake is $8. The delivery boy is paid $3 per delivery, and each box used for packaging costs $2. The bakery sells 20 cakes per day, with double that amount on Christmas, New year, and Valentine’s Day. What would be the total variable costs for the Winter months?
Calculations
Step 1
The first step would be to determine the period. Winter months include December, January, and February. Both December and January have 31 days. Since the bakery opened in 2019, January and February calculations are for 2020. 2020 was a leap year, meaning February has 29 days [Always read the instructions carefully and be alert!]
Number of Days = 31 + 31 + 29 = 91 days
Step 2
The total output would be cakes produced per day x the number of days. The bakery bakes 20 cakes per day, except Christmas, New Year, and Valentine’s Day on which they bake 40 cakes. Thus, the total output is:
Total output = (88 x 20) + (3 x 40) = 1760 + 120 = 1880 units
Step 3
Calculate the variable costs per unit. This would be the sum of the cost of labor, direct materials, packaging, and delivery.
Variable costs per unit = 7 + 8 + 3+ 2 = $ 20 per unit
Step 4
Calculate the total variable costs, by multiplying the total output by the variable costs per unit produced.
Total variable costs = 1880 x 20 = $ 37,600
Example 2
“Iron fist” is a company that owns a fork production factory. The factory operates two machines and produces 400 forks per day. Ten workers are working at the assembly line and each makes 5 forks per hour. They get paid $ 10 per hour and the material costs for each fork add up to $4. The company wants to open up another factory, however, first, they need to calculate the costs. The total costs for the month came out to $ 123,600. The fixed costs are given below:
| Item | Cost (per month/November) |
| Machine | $ 18000 |
| Factory space rent | $ 12000 |
| Utilities | $ 1000 |
| Insurance | $ 2600 |
Calculate the total variable costs per month.
Calculations
To calculate the total variable cost, we first need to find the total fixed costs and subtract them from the overall costs.
Total fixed costs = (18000 x 2) + 12000 + 1000 + 2600 = $ 51,600
Total Variable Cost = Total cost – Total fixed costs = 123600 – 51600 = $ 72,000
We could even double-check this. If each worker makes 5 forks per hour, then one worker produces one unit every 12 minutes.
1 hour = 60 minutes = 60/5 = 12 minutes
Additionally, if they get paid $10 per hour, it means they get paid $2 per unit. Thus, the variable cost per unit of the fork would be:
Variable unit cost = labor cost + material cost = 2 + 4 = $ 6 per unit
Total variable cost = 400 x 30 x 6 = $ 72,000
Additional Information and Tips
Point 1
Variable costs are a crucial component for businesses when determining the optimal pricing strategy. Modern markets are very competitive, especially when so many products are similar. Thus, competitors think of creative ways to stand out and secure a loyal customer base. Quite often, one way is through competitive pricing. Variable costs help companies better understand the components of the production process. This information helps determine the optimal pricing to generate enough revenue to cover the costs.
Point 2
It is possible to decrease the variable costs as the company and production grow large enough to enjoy the economies of scale. Economies of scale help increase operational efficiency and provide companies with negotiation leverage to secure competitive pricing on things such as raw materials, shipping, etc.
Point 3
Break-even analysis is an important concept that helps entrepreneurs and business owners find out the point when a business will start generating profit. Such a point is when enough revenue is generated to cover production costs and the initial investment. All the sales after this point are profits. The key elements to calculating this point are variable and fixed costs. The formula to calculate the breakeven point is:
Breakeven point = Total fixed costs / Contribution margin
Contribution margin = Price per unit – Variable cost per unit
The contribution margin represents the amount of revenue left from selling one unit of a product to cover fixed costs (as the variable costs are accounted for). When contribution margin = Total fixed costs, then the company is at the breakeven point. If the contribution margin > fixed costs, then the company is starting to make a profit.
This analysis helps us see that companies with higher variable costs and lower fixed costs need to produce less to break even. On the other hand, they also have a lower profit margin than companies with higher fixed costs.
Point 4
Companies with a higher variable than fixed costs also benefit during times of economic crisis. Since variable costs are directly tied to production, a company can cut costs quickly, when necessary, by decreasing production.
Point 5
A frequent question is whether labor is a fixed or variable cost. Salaries paid to employees are considered fixed costs as they are independent of the company’s output and production- they are paid regularly. However, the money paid to workers based on the number of units they produce or hours they work is variable as it changes depending on the activity level.
Point 6
On a diagram, Variable costs are parallel to total costs. fixed costs, since they are constant and independent of the production level will be represented with a perfectly horizontal line. Variable costs on the other hand will be exactly parallel to the total costs. Additionally, the difference between TC and VC is equal to FC at every point.
