What is Variable Cost?
A variable cost is an expense that rises or falls in direct proportion to production volume. Variable costs differ from fixed costs, which remain the same even as production and sales volume changes.
Common variable costs include:
- Raw materials
- Sales commissions
- Labor directly associated with production
- Credit card fees
Calculating Variable Cost
Where fixed costs are simply added together to find a company’s total fixed costs, variable costs must be multiplied. Total variable costs are found by calculating:
Total variable costs = Quantity of products produced x Variable cost per unit
For example, the total variable cost for 10,000 units produced at a per-unit cost of $2.57 is $25,700.
Impact on Profitability
A business with higher variable costs relative to fixed costs is likely to have more consistent profitability. That’s because the break-even point is lower, due to lower fixed costs, and higher variable costs yields lower profits per unit sold.
Conversely, a company with lower variable costs and higher fixed costs will likely have higher profits once its fixed costs are covered. That’s because once break-even is achieved, profits are higher per-unit, thanks to lower variable costs.
As production volume increases, it is often possible to negotiate, or renegotiate, purchasing agreements to further reduce your per-unit cost. That is especially true with raw materials and shipping. The higher the production volume, the greater your negotiating power.
The one variable cost you may have difficulty negotiating is direct labor costs. One strategy for reducing those costs is to switch to a payment-per-piece produced, rather than an hourly wage. That way, labor costs are truly tied to production.