Variable Cost With Example And General Overview

By Sean Stevenson – Latest Revision January 31st, 2021

What Is A Variable Cost?

A variable cost is a business expense that reflects the amounts of goods or services being produced. 

For every output there is an inevitable cost.  This means that the more goods or services being produced, the higher variable cost is inevitably going to be. 

Conversely, a smaller amount of goods or services being offered, will have a lower variable cost.

Example

The packaging used to contain a product is an excellent illustration of a variable cost. 

As more goods are produced, so too must more packaging be used.  This packaging is not free for the business and must be paid for. 

Any business will have a price to pay for its typical operations.  Some may use raw materials, packaging, or even data. 

Any of these examples would illustrate the principle of a variable cost.

Key Takeaways

  • A variable cost is a business expense that reflects an organization’s productive output.
  • Should production decrease or increase, inevitably, the variable cost would match the trending output.
  • A good way to think of variable cost examples, are things the business requires for its operations to remain effective.  This can include raw materials, packaging, direct labor costs, or even data.

Understanding Variable Cost

A variable cost is much as its name implies.  It is a variable (not fixed) expense that a business must incur in order to continue its operations.

The opposite of a variable cost is a fixed cost.  This type of expense is constant and does not change.

The important distinction is that a variable cost fluctuates based on productive output.  The higher the productive output, the more pronounced the associated variable costs will be.  In turn, the lower the productive output, the less variable costs will be incurred by the business model.

The contrast of both variable costs and fixed costs combined, represents the total expense incurred by a business.  Essentially, both variable and fixed costs are separate categorizations of what a business must pay to effectively function in its day-to-day operations. 

Variable Cost Examples

  • Utility Costs- Some industries use vast amounts of electricity to power their enterprise and its operations.  The more output occurring, the more energy will be needed to fuel the productive efforts.  Conversely, if some machines are shut down -for whatever reason- then the variable cost will decrease as a result.
  • Raw Materials Costs- Any type of raw materials used in the productive process will represent a variable cost.  The more output occurring, the more raw resources will be needed to supply the production taking place.
  • Labor Costs- Direct labor costs from employees.  Paying workers represents a clear ongoing concern for any stable operation.  The continual costs associated with payment of employees will differ depending on how large the output.  The more workers needed, the higher the associated variable cost will be.
  • Sale Commissions- A sales team that receives commission will represent another example of variable cost.  The higher the output and sales of the organization, the more commission sales will be made. 

Differentiating Variable Cost vs. Fixed Cost

The two costs represent the total expenditure of a company.  They are best thought of as differing categorizations of an organization’s owed amounts to third parties. 

Variable cost fluctuates based upon productive output volume.  Whereas fixed cost remains the same in any event.

Variable Cost With Example

In the case of variable costs, the expense is only existent if production is occurring.  This means that if a company fails to produce -for any reason- then it likely has little to no real variable costs to be concerned with.

Unfortunately, if this same company is failing to produce anything for an extended period of time, then the fixed costs associated with its existence would still apply.  Fixed costs can be associated with “basic financial necessities of life” when operating a business.

Understanding Fixed Cost

No matter the circumstances, fixed costs must be paid.  They are continuous, regardless of what is happening at the ground-level. 

Even if a company were to shut itself down for maintenance or otherwise, the rent must still be paid.

Fixed costs can change over time.  Rates may go up or down depending upon fluctuations in the market.  They are best viewed as consistent long-term costs associated with conducting business.

Examples

  • Employee rates or salaries.
  • Association benefits.
  • Building rent.
  • Any form of work-related insurance.

Understanding Semi-Variable Costs

A final technical category of business expenses exists.  These are known as semi-variable costs.  They are also sometimes referred to as “semi-fixed costs” or “mixed costs.” 

Semi-variable costs are essentially a “mix” of variable and fixed expenditures.  They tend to be the rarest category of a company’s expenses. 

Semi-variable costs are characterized by being fixed up until a predetermined level of production or consumption.  Once this level has been reached, the cost reverts to a variable rate.

In essence, semi-variable costs potentially operate as both a fixed and variable expense.  Often, even if production is halted, a fixed expense will still be incurred under a semi-variable cost.

Example

A semiconductor fabrication plant uses as much power as about 50,000 homes in a typical year.  It pays a fixed cost for its electric supply for the majority of its annum. 

However, once it passes a certain point of consumption towards the end of its year, it incurs a variable rate instead.  While the added expense is not crippling, it is nonetheless designed by local government to discourage overconsumption.

Visualized Example Of A Variable Cost

An automotive production plant is reporting to the board of directors.  The variable cost example below illustrates the expenditures of their operation.

The raw materials required for the manufacturing of a single car is $20,000.  Further, the employee rates associated with manufacturing each car represents a further $1,000.  Lastly, the sales commissions involved at participating dealerships, represents a $500 addition to the variable costs involved.

From these amounts, we may visualize how a productive process directly impacts the total variable cost.  This gives us insight into the financial nature of an organization’s operations.

 

1 Car

2 Cars

8 Cars

20 Cars

0 Cars

Cost of Raw Materials

$20,000

$40,000

$160,000

$400,000

$0

Employee Rates of Pay

$1,000

$2,000

$8,000

$20,000

$0

Sales Commissions

$500

$1,000

$4,000

$10,000

$0

Total Variable Cost

$21,500

$43,000

$172,000

$430,000

$0

As depicted above, the relation of the production process to the actual variable costs associated, paints a clear picture of the correlation between the two.  Without any production occurring whatsoever, the variable costs become nonexistent.  Conversely, the more production occurring, the more variable costs will be associated with the workflow process.

Below is a depiction of these trends.

Variable Cost With Example

As noted, the variable cost ebbs and flows with the production volumes.  As output increases, so too, will the variable cost.

How To Calculate Profits

Once a company has determined its total expenditure, it can then calculate its profits. 

To be clear, it must first discover the exact amounts of variable costs and fixed costs to do so.  This would be a clear determinant of its total costs, which could then be compared to its total sales.

The formula for calculating profits is calculated by:

Profits = Sales – Total Costs

For any modern company, increasing profitability is a constant concern.  Fixed costs tend to be immovable, or extremely challenging to have any real effect on.

Therefore, variable costs represent a much more malleable expenditure that can be acted upon.  Most organizations today, focus on reducing their variable costs.

For simplification, we will consider a bike shop: 

The bike shop sells each bike for an average of $100.00. 

Its variable cost for materials per bike is $21.50. 

The fixed cost for rent and all utilities is $1500.

Using these metrics, we can analyze its profitability when compared to the total variable cost and the total fixed cost.

Let us assume each row is representative of a single month of business activity.  The total sales and actual profit taken, are displayed below:

Amount Sold

Total Variable Cost

Total Fixed Cost

Total Cost

Sales

Profit

10 Bikes

$215

$1500

$1,700

$1,000

$(-700)

75 Bikes

$1,612

$1500

$3,112

$7,500

$4,388

125 Bikes

$2,687

$1500

$4,187

$12,500

$8,313

250 Bikes

$5,375

$1500

$6,875

$25,000

$18,125

 

A business will have a certain margin of profitability that it must maintain to stay in operation.

Note the loss the business incurred when sales were too low.  10 bikes were simply not enough to financially sustain the existing operations.  In effect, this caused a $700 financial loss in a single month.

While the loss for the previous month was unfortunate, the bike shop poured its efforts into obtaining new customers by word of mouth.  As a result, the next month proved profitable, and customers actively promoted their goods.

The table above represents an excellent variable cost example.  Used in tandem with fixed cost, total cost, sales, and profit, we can quickly come to terms with an operation’s level of financial success.

A company such as the one depicted above, would likely be searching for ways to decrease its variable costs.  This would require cutting expenditure on raw materials, advertising, or direct labor.

However, it should also be noted that any effort at eliminating cost must also not have a negative impact on the quality of the service or product being offered.  If quality were to suffer, then it is also likely that overall sales would diminish as a direct result.

Extrapolating the Contribution Margin

The contribution margin is often used by business owners and managers as a means of understanding the profits made from each good or service rendered.  This allows for better decision-making when considering different supplier or labour-related costs.

Using the contribution margin, a business can discover a “happy medium” where it does not sacrifice quality but can still find a solid margin of profitability.

Example

A plastics company finds its production resins are too expensive.  In other words, while making their plastic overlay, they are spending too much on their raw materials.

They soon discover a cheaper source of plastic resin, which seems consistent with their customers expectations.  In using this cheaper variant, each product sold contributes more to their contribution margin.  This adds greater profitability to their existing operations.

To calculate the contribution margin, use the following formula:

Contribution Margin = (Sales – VC) / Sales

Where:  VC= Variable Costs

As in the example above, the contribution margin for the bike would be:

$100-$21.50 / $100 = 0.785 or 78.5%.

By reducing its variable costs, the bike shop would be able to heighten this contribution margin.  This would mean its profit margin would increase also.

As an example, if the bike shop could reduce its variable costs by 50%, the formula would now look like this:

$100-$11.25 / $100 = 0.8875 or 88.75%. 

Having reduced its variable costs by 50%, each unit sold would now heighten the contribution margin by a staggering 10.25%!  While this may not seem like a large quantity, it in fact would add up significantly over time.  Especially in a scenario where increasingly large volumes of goods or services were being sold.

Its easy to see why large companies spend a great deal of time focusing on reducing their costs and increasing their contribution margins.

Your Business Leadership Story

Take Action

Subscribe to our free newsletter!

Get more information, resources, and tools to help you on your professional journey!  Jumpstart your career today!

  • Learn new skills
  • Gain the latest professional expertise and insights
  • Get informed news, articles, courses, and practical advice
Subscribe
Notify of
guest
0 Comments
Inline Feedbacks
View all comments

Related Articles

SMART Goals - For Better Results In Business

Do you ever sense that you could be accomplishing much more? Many people spend years, even decades, rushing from one excess to the other. They never achieve their goals, much less improve their skills. If you want to achieve more and fulfill your dreams, you’ll need a comprehensive plan.

The Quality Of Earnings

Understanding the quality of earnings is integral for investors seeking to understand attributable core income and accounting. For enterprising business leaders too, the uses and contrast of this term are integral to promoting intelligent discussion about the fiscal health of an enterprise.

SWOT Analysis - For Growing Your Business

Do you ever feel you would like to start a new business or develop an existing enterprise? Effective SWOT analysis can help you do just that. Many people spend years with these questions in mind, without ever developing a realistic strategy to implement their dreams. SWOT analysis allows for anyone to develop a cohesive business strategy.

Management By Objectives - For Optimal Business

Do you need for a more strategic approach to improving the overall performance of your organization? Most business owners would say yes. This is to say that the majority of organizations polled in various studies, did not have a strategic approach to leading their organization forward into the future.

Copyright © 2020 leadershipdean.com. All rights Reserved.

leadershipdean.com
0
Would love your thoughts, please comment.x
()
x