Variable costs are business expenses that vary depending on the number of goods or services you produce. These costs increase as your company's revenues increase and decrease when revenues decrease.
This article will help you understand exactly what variable costs are, how to calculate them, and why they matter to your business.
What Is a Variable Cost?
Variable costs are recurring expenses that change depending on how many goods your business produces or how many services you provide. They're the opposite of fixed costs, which stay the same no matter how your production volume changes and must be paid even if your company doesn't produce anything.
Variable costs combined with fixed costs make up your business's total costs.
Examples of Variable Costs
Every business has variable costs, but the types of variable costs your business pays depend on the type of goods or services you produce.
Some common examples of variable costs include:
- Direct materials. The raw materials that go into producing a product or delivering a service. For example, the wood used in manufacturing furniture
- Direct labor. The amount paid to workers who produce goods or deliver services.
- Shipping costs/freight. The cost of packing and shipping finished goods to customers.
- Supplies. Supplies consumed during the production process, such as machinery oil.
- Commissions. Amounts paid to reward salespeople.
Some common fixed costs include rent and salaries paid to administrative employees because they stay constant no matter how many goods or services the business produces—at least for a while.
How to Calculate Variable Costs
The formula to calculate variable costs is: Total Quantity of Output x Variable Costs Per Unit of Output = Total Variable Costs.
For example, say you own a graphic t-shirt company. It costs $12 to produce one t-shirt, including materials, labor, supplies, and shipping the final product to the customer. In June, you sell 300 t-shirts. Your total variable cost would be 300 x $12, or $3,600.
Why Are Variable Costs Important?
It's important to keep track of your company's variable costs because they help you set prices for your products or services and ensure your business is profitable.
Returning to the example above, say you sell each graphic t-shirt for $20. That means you're making $8 per shirt after taking variable costs into account. However, you still have fixed costs to pay. That's where calculating your break-even volume comes in handy.
You calculate your break-even volume by dividing your fixed costs by your revenue per unit after variable costs.
Say the fixed costs for your graphic t-shirt business are $1,600, including rent, utilities, advertising, and insurance. Your revenue per t-shirt sold is $8. Therefore, your break-even volume is: 1,600 ÷ 8 = 200.
So, you need to sell 200 t-shirts each month to break even. Since you sold 300 t-shirts in June, you're able to turn a profit.
However, you want to start using higher-quality t-shirts that cost $4 more per shirt. Now, your variable cost per unit is $16 instead of $12, and your revenue per shirt sold is $4. Your break-even volume would be: 1,600 ÷ 4 = 400.
With variable costs of $16 per t-shirt, you would need to sell 400 shirts per month in order to break even. You either need to price your graphic t-shirts higher, lower your fixed costs, or figure out how to sell a lot more shirts each month without spending more money.
It's always a good idea to have a clear understanding of the types of costs you incur in your business. Both fixed and variable costs play a crucial role in your business's profitability and growth. If you're having trouble managing business expenses, reach out to your accountant. They can help you track variable and fixed costs, calculate your break-even point, and make pricing decisions.