Variable costs and fixed costs comprise the total cost of your business activity. While these costs seem complicated at the first plan, you’ll just make a little math to figure out how much they cost.
In this part, we'll explain fixed cost vs variable cost and guide you on how to calculate variable costs in a simple way, so you quickly understand the nature of variable costs and how they affect your profitability before making any business decision.
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What is a Variable Cost?
A variable cost is an expense that changes in proportion to the volume of production output or sales. In other words, the increase or decrease of variable costs depends on a company’s production or sales volume in direct ratio. Particularly, the variable cost of production is a constant amount per unit produced, so it will increase as the volume of production and output increases. Conversely, when fewer products are produced, the variable cost associated with production will consequently decrease.
Types of Variable Costs
+ Direct Materials and Supplies: The cost of raw materials varies with your production volume. Efficient management here means avoiding wastage and unnecessary expenses.
+ Direct Labor: Labor costs fluctuate with production changes. Optimizing these costs ensures effective staffing levels, improving profitability.
+ Utilities and Operational Expenses: Costs like utilities change with production intensity. Monitoring these helps in reducing expenses through energy efficiency.
+ Commission and Sales-Related Expenses: Sales-related costs rise with increased sales. Managing these effectively is key to maintaining a healthy profit margin.
+ Shipping and Transaction Fees: These vary with product sales and shipments. Negotiating better rates can lead to significant savings.
The most common variable costs include direct materials, direct labor, transaction fees, utility costs, commissions, billable labor…In short, if a cost varies depending on the volume of a business’s activity, it is a variable cost.
Contact Irvine Bookkeeping for expert assistance in managing variable costs and boosting your business's financial health.
Read More: Operating Expenses vs Cost of Goods Sold
Variable Costs vs. Fixed Costs
The total expenses incurred during any corporate activity consist of variable and fixed costs. Understanding the difference between variable costs vs. fixed costs is crucial to business decision-making.
The difference between fixed costs and variable costs is that variable costs are dependent on production output or sales. Fixed costs, on the other hand, are independent and remain constant regardless of production levels.
Fixed costs are expenses that are associated with the basic operation and overhead costs of a business. Since fixed costs are usually established by contract agreements or scheduled a business pays those amounts, regardless of the level of production or even no production occurs. Some common fixed costs include renting or leasing a building, utility bills, website hosting, and property taxes.
There are some costs that fall between fixed and variable costs, which are categorized into semi-variable costs (also known as semi-fixed coss or mixed costs).
Both variable costs and fixed costs play important role in bookkeeping tasks. Variable costs are usually viewed as short-term costs that can be adjusted. Fixed costs are allocated under the indirect expense section of a company’s income statement which leads to operating profit.
How to Calculate Variable Costs
Your total variable cost is the sum of all variable costs associated with each individual production.
To calculate variable costs, you’ll need to do a little math. The total variable cost is simply the quality of output multiplied by the variable costs per unit of output:
Total Variable Cost = Total Quantity of Output x Variable Cost Per Unit of Output |
For example, it costs $100 to produce one unit of your product and you’ve made 50 units, so you calculate the variable cost by $100 x 50, or $5,000.
Calculating profit margin with variable costs
Both variable and fixed costs are essential to getting a complete picture of how much it costs to produce an item and how profit remains after each sale. Here’s the formula for finding your profit margin on each unit produced:
Profit margin = Retail price per unit - Variable cost per unit |
For example, you sell a T-shirt for $20 each, shipping included. Each T-shirt costs $12 to make. After selling one, you earn $8 per T-shirt.
Variable costs and breaking even
When calculating your profit margin, you’re taking variable costs into account, and making $8 per product. However, you still have fixed costs to pay. Every month you need to pay those costs to stay in business. So you need to calculate the break-even volume which is the number of units you must sell every month in order to pay your fixed costs. Here’s the break-even formula
Break-even volume = Fixed costs/ Revenue per unit after variable costs |
For example, you have to pay the fixed costs for the T-shirt store monthly. The total fixed cost is $1200 per month, including rent, utilities, e-commerce site. Using the calculation: 1,200/8 = 150. So you’ll need to sell 150 T-shirts per month to break even.
Benefits of Managing Variable Cost
Optimizing Financial Resources
Effective management of variable costs, like direct materials and labor, enables more accurate budgeting and financial planning. This ensures optimal resource allocation, crucial for small to mid-size businesses.
Enhancing Profit Margins
By reducing variable costs, you can significantly boost profit margins. This financial flexibility is essential for weathering market fluctuations and maintaining competitive pricing.
Increasing Competitiveness
Lowering variable costs allows for more competitive pricing, giving you an edge in today's market, especially against larger competitors.
Facilitating Scalable Growth
Managing these costs effectively supports sustainable growth, crucial for long-term business success.
Irvine Bookkeeping offers personalized bookkeeping and tax services to help you manage variable costs efficiently. Contact us to enhance your business's financial health.
How Can A Business Reduce Variable Costs?
You can increase your profits by decreasing the total cost. Since fixed costs are more challenging to bring down, you can seek to reduce your variable costs. There are a number of ways that you can apply to reduce its variable costs.
Method for reducing variable expenses | Examples |
Spend less on direct materials |
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Spend less on direct labor |
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Save on card transaction fees |
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Reduce the cost of distribution |
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Once you’ve already tightened up variable costs for your business, it’s time to look at your fixed expenses. Remember that the costs you decide to cut down should not affect product or service quality as this would have an adverse effect on sales. By spending less on these variable costs, your business can increase the gross profit margin.
Read More: Deducting Business Expenses
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