Variable Costs: A Definition

Tracking your revenue is a key part of running a business. But if you want to make a profit, so is keeping an eye on your costs. Understanding variable costs and where they fit within your business expenses is therefore key.

What is a variable cost?

A variable cost is a cost that changes with the level of output or production. In other words, it is a cost that increases as production increases and decreases as production decreases. Variable costs are typically calculated per unit of output, such as per product produced or per mile driven.

Variable cost examples

So, what exactly constitutes a variable cost? As we said, the variable cost rises and falls according to your production output. Here are some of the most common ones you might incur:

• Raw materials: one of the major costs, particularly if you produce a physical product.
• Production supplies: any supplies directly associated with manufacturing will fluctuate according to production volume.
• Shipping costs: if you physically send goods, this total will go up and down depending on the volume you send.
• Commission rates: commission is only paid on sales, so the more you sell, the more this will rise.
• Direct labour: if you pay staff by the hour to make your goods or services.
• Credit card fees: if you take card payments, you’ll pay fees per transaction.

For accounting purposes, variable costs are considered short-term because you can quickly move to change them. For example, they can be changed simply by getting a new supplier. Fixed costs, on the other hand, are long-term. They do still change over time due to things like salary increases, but tend to remain steady for relatively long periods.

Variable costs vs fixed costs

As we’ve said, the definition of a variable cost is a cost which changes depending on your product or service output.

Fixed costs, however, remain the same no matter how much you produce. Your rent, insurance and employee salaries (unrelated to direct production) will still have to be paid each month, no matter your production volume.

Calculating total variable cost

To calculate your total variable cost, you need to multiply the cost per unit by the total number of units produced.

For example, a factory makes reusable water bottles. It costs $1.50 to make each bottle. If they make 1000 bottles the total variable cost is 1000 x 1.5 = $1,500.

To calculate your gross profit you subtract the cost of goods sold (your variable costs) from the total revenue (the amount you sold the goods for).

Impact on profit

A company with low fixed costs and high variable costs usually enjoys consistent profitability. If their variable expenses increase, they can quickly move to reduce them and keep profitability high. This is much harder for companies with a lot of fixed costs to achieve due to a higher break-even point and the relative difficulty of bringing down costs.

However, a company with higher fixed costs is likely to enjoy greater profitability once those costs are covered.

As production increases you can negotiate lower prices for raw materials with your suppliers. This is known as economies of scale. Direct labour costs, on the other hand, are often difficult to renegotiate. But a model in which staff are paid proportional to units produced can help better correlate costs and production.

Frequently asked questions

Which cost is an example of a variable cost?

The cost of raw materials is a core example of variable costs. If your business makes cakes, for example, you’ll need raw materials such as eggs, butter and flour. As those prices fluctuate, so will your business expenses.

Can variable costs be indirect?

Technically they can. Let’s take electricity as an example: this may rise or fall depending on the number of units made in a factory, but consumption can’t be tied directly to one specific product.

How do you find the variable cost?

To calculate variable cost, you multiply the amount it costs to make a single unit by the total number of units sold.