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' 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:
Units of product/service provided x variable costs per unit = 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 doing so helps you set prices for your products or services to ensure you are maintaining profitability with each product sold. Note that if variable cost per unit exceeds the sales price, the company will certainly not be profitable. Secondly, you must consider whether you will sell enough to overcome your fixed costs.
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 contribution margin and break-even volume comes in handy. The amount left over after deducting variable costs from the product sales price is known as the contribution margin. The break-even volume is the amount you need to sell, whereby the profit from the products sold will equal your fixed costs.
Contribution margin = Sales price per unit minus variable cost per unit
Break-even volume = Fixed costs divided by contribution margin
Say the fixed costs for your graphic T-shirt business are $1,600, including rent, utilities, advertising, and insurance. Your contribution margin per T-shirt sold is $8. Therefore, your break-even volume is 1,600 divided by 8 = 200 T-shirts.
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 divided by 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 these premium T-shirts higher, lower your fixed costs, or sell more T-shirts than before.
Both fixed and variable costs play a crucial role in your business' 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 contribution margin and break-even volume, and help you price your company’s products or services to maximize profit.
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