What is a variable cost? | Learn more
The amount of money many businesses spend is in many ways directly proportional to what they produce. That is, there are a lot of variable costs associated with running a business. These costs are periodic and vary depending on the level of production or sales of a business. These costs can include labor, raw materials, distribution costs, etc. Variable costs are correlated with production: the more a company produces, the higher its variable costs.
In most cases, the variable costs of a business are synonymous with its cost of goods sold (COGS). They oppose fixed costs and tend to play an important role in a company’s ability to meet its profit requirements. While fixed costs are known, variable costs are not always; however, many companies have models to predict them. Nonetheless, these costs can be generic in a company’s cash flow reports and income statements. Here’s how to understand them and take them into account.
Examples of variable costs
When thinking about variable costs, it’s easier to just look at the COGS. Everything that is included in the COGS is a variable expenditure because it is related to the total production of goods or services. The most common examples include:
- Raw materials, components and packaging
- Labor hours and production costs
- Credit card transaction fees
- Shipping or receiving costs
Depending on the goods or services it produces, a company’s variable costs can cover many different contributors to COGS. Some companies have very few; others have a lot.
Traditionally, investors view companies with more variable costs and less fixed costs as more attractive than those with more fixed costs. This is because it is easier to achieve profitability and control risks in the upward and downward production cycles. More fixed costs set the breakeven point for higher profitability.
Variable costs change at different rates
An important factor to remember about variable costs is that all the variable costs are themselves variable. A good example of this is material costs versus labor costs. For example, purchasing materials for a widget can cost $ 2 and 0.25 hour of labor to assemble it, paid at $ 15 / hour. If you pay employees hourly wages (rounded). The cost of producing a widget is $ 17; however, the workforce covers four Widgets per hour, which equates to $ 25 / hr. Anything beyond the fourth unit adds another hour of work, immediately resulting in an expense of $ 15.
In this example, the variable cost of labor increases at a quarter of the rate of materials. Yet both are still variable costs as they depend on the number of widgets produced by the company. Businesses sometimes face dozens of different costs, which can make it difficult to understand financial reports on metrics like gross profit or cash flow.
Comparison of fixed costs
As the name suggests, variable costs go up and down depending on the factors of production. Conversely, fixed costs remain the same, immutable no matter how much the company produces. For example, if a company increases Widget production from 1,000 to 1,500 per month, the cost of materials will increase by 50%. However, the cost of the Widget Factory rent will remain the same. Likewise, if Widget’s production was increased from 1000 to 500, the cost of materials would drop by 50%… and the cost of rent would remain the same.
There is actually a category between true variable costs and true fixed costs, called semi-variable costs. These generally involve costs set at a certain level of production. For example, a company may have fixed prices for raw materials up to 1,000 units, with variable prices for all units above that threshold.
How do variable costs affect gross margin / profit?
Since the variable costs represent the COGS, they have a direct impact on important parameters such as gross margin and gross margin. As these costs increase, the gross margin and profit tend to decrease. Conversely, if companies manage to reduce their COGS, they will increase their gross margin and profit.
Companies looking to reduce or control variable costs need to identify them and their impact on business results. For example, a company may negotiate broken prices for raw materials on certain quantities in an attempt to keep those costs lower as production increases. This, in turn, preserves gross margin and profit even in the face of rising variable costs.
Why is it important to plan for variable costs?
Companies actively monitor variable costs in order to better model them. This is an important practice because it makes it possible to determine the profitability of a company according to the behavior of its costs in relation to its production. For example, the business needs to know by how much its COGS is increasing as it increases production, so that it can determine acceptable thresholds for gross margin and profit.
Predicting these costs also provides insight into the future performance of the business. If the company produces 1,000 Widgets this month and plans to produce 1,200 next month, it can estimate future costs even though they are variable. Additionally, it can compare expected COGS to expected sales to predict profits. This is a common practice among public companies, which set profit targets for investors to follow.
The bottom line
While variable costs can continuously rise and fall, they provide an opportunity for businesses to exercise control over their bottom line. Forecasting these costs provides a framework for understanding how the business will perform in the near future. Identifying specific variable costs and finding ways to reduce them can improve gross margin and profit. And, more importantly, fixed costs give a business more opportunities for growth, as opposed to fixed costs, which remain steadfast, ubiquitous.
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