Every business must contend with a broad range of costs and expenses associated with startup, operations, and growth. Some of these costs remain relatively constant over time. For instance, unless you’ve moved or signed a new lease, the cost of rent for storage or manufacturing facilities will stay the same.
However, other costs can vary significantly as your business grows. These are called variable costs.Click here to start selling online now with Shopify
In this guide, you’ll learn the definition of variable cost, how to calculate variable cost, and how variable costs can impact the profitability of your business.
Table of contents
- What is variable cost?
- Types of variable costs
- How to calculate variable costs
- Importance of variable cost to business
- Variable costs and economies of scale
- Variable cost FAQ
What is variable cost?
Variable cost is a business expense that rises or falls in direct proportion to production volume. The more goods a company produces, the higher variable costs become, and vice versa. While total variable costs change based on production volume, the variable cost per unit produced remains constant.
Variable cost vs. fixed cost
Variable and fixed costs both represent key expenses of running a business. However, while variable costs change depending on production, fixed costs remain the same even as production and sales volume changes.
Common fixed cost examples include:
- Property taxes and interest
- Some utility costs
Variable and fixed costs are key elements of break-even analysis, which helps businesses determine what they need to do or produce in order to make a profit on their initial investment.
Variable cost vs. marginal cost
While variable cost often measures the cost to produce each unit, marginal cost considers the total cost of production (including both fixed costs and variable costs) to find the cost of producing one additional unit with the goal of maximizing efficiency in the manufacturing process.
Types of variable costs
Common variable cost examples include:
- Raw materials. If you’re manufacturing your own product, these costs are allocated to the materials you purchase in order to produce the goods. This is a variable cost that should remain fairly consistent.
- Sales commissions. If you operate on a commission structure, either for associates or brand ambassadors, for example, this is another variable cost to consider. It changes depending on the way you have commission structured and number of products sold.
- Packaging. Product packaging and shipping materials are another necessary cost. These vary depending on the quality, material, and design of packaging as well as the total amount of packages and their sizes.
- Shipping costs. Shipping expenses vary depending on the shipping method, location, and package size and weight.
- Labor (when workers are paid per unit completed). 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.
- Credit card fees. Credit card fees are a variable cost because they vary depending on sales volume. In some cases, you may pay a flat subscription fee for credit card processing, but these vary for most businesses.
How to calculate variable cost
Where fixed costs are simply added together to find a company’s total fixed costs, variable costs must be multiplied. The formula to calculate variable costs is:
Total variable costs = production output x variable cost per unit
For example, the total variable cost for 10,000 units produced at a per-unit cost of $2.57 would be $25,700. (This cost per unit is often referred to as average variable cost, as it’s calculated by dividing total variable cost by the number of units produced).
Importance of variable cost to business
Variable costs can have a significant impact on the profitability of a business. Below are some ways variable costs impact your business.
- Consistent 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.
- Protection during slow sales periods. A company with higher variable costs can bear economic downturns more easily by reducing production.
- Competitive advantage. Conversely, a company with a higher proportion of fixed costs to variable costs requires a significant upfront investment, but will likely enjoy lower competition and higher profits once fixed costs are covered. That’s because once break even is achieved, profits are higher per unit, thanks to lower variable costs.
- Inform pricing. Knowing your variable costs is important to ensure you’re pricing profitably.
Variable costs and economies of scale
While variable costs generally increase with more production, it’s possible to lower variable costs by achieving economies of scale. For instance, by focusing your manufacturing on fewer products, you can save on costs associated with running multiple product lines, including sourcing materials, maintaining equipment, and managing different business units.
In addition, as your production volume increases, you gain leverage to negotiate more competitive prices for variable costs like raw materials and shipping, further decreasing your variable cost per unit.
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