Variable Cost: Definition, Examples, Formulas and Importance

Variable cost is an accounting term used when calculating a company's production expenses. Determining the variable costs involved in operating a business is essential for maintaining efficiency and profitability. Understanding variable cost can help you perform more accurate cost analyses and allow you to make better business decisions.

In this article, we define variable cost and provide a list of examples, including the formulas used to calculate variable cost per unit and total variable cost.

What is a variable cost?

Variable cost is a production expense that increases or decreases depending on changes in a company's manufacturing activity. For example, the raw materials used as components of a product are variable costs because this type of expense typically fluctuates based on the number of units produced.

Variable costs change depending on output quantity. An increase in output elevates costs, while reduced output leads to a decrease in costs. In contrast, fixed costs remain the same regardless of production or manufacturing output. Therefore, variable costs are also the direct costs of production volume, rising in response to the increase in production and decreasing with lower production.

Related: Fixed vs. Variable Costs: Definitions and Examples

Examples of variable cost

Here are some of the most common types of variable costs for a business:

Direct materials

Direct materials are the inventory of raw materials purchased by a manufacturing or retail company to create finished goods or merchandise. Direct materials cost is, therefore, the cost of all the items used in the manufacture of a product. These tangible materials are all measurable and identifiable as contributing to the product.

Examples of direct materials include steel used in building construction, circuit boards used in computer assembly and fabric used in producing clothes. Materials such as glue used in shoes or the grease used in machinery aren't direct materials because they aren't easily identifiable in the final product, and you can't determine the amount used in each product. These items are production supplies.

Packaging materials

The materials that are used for packaging goods are variable costs because the amount used may vary depending on the volume of sales and production. Some companies opt to reduce the number of packaging materials used for a product when the production volume or sales volume decreases.

Examples of materials used for packaging are bags, boxes, twist ties, plastic wrappers and foil. Most companies consider the cost of packaging materials when determining product profitability.

For example, a food service company might spend about $500 on plastic wrap to pack 2,000 sandwiches. A product profitability analysis might determine it could lower production costs if it bought plastic wrap in bulk.

By strategically adjusting the true cost of its sandwiches, it may spend double that amount to make 4,000 sandwiches, and doing so may more than double the revenue of selling 2,000 sandwiches because of the economies of scale when costs spread out over a higher volume of output.

Piece-rate labor

This is the amount that employees earn for every unit they complete or sell. Employee input typically determines the cost of piece-rate labor. This cost also increases or decreases along with the rate of production.

Companies may resort to piece-rate labor when the cost of monitoring production volume has to conform to the quality of the work performed. Piece-rate labor is also the preferred method of payment when production requires personnel with variable skills.

Piece-rate labor falls into the category of variable costs because sales personnel earn their payments only if they can sell products or services. Employees who surpass sales goals may receive commissions.

Sales commissions are an example of piece-rate labor because they often vary based on a company's profits and an employee's productivity. A company may withhold commissions if it doesn't meet its profit margin or if employees don't meet their sales quotas.

Related: What Is Profit Margin?

Freight out

Businesses incur shipping costs when they sell and distribute products. Therefore, freight out is a variable cost. Shipping costs are the expenses that a company incurs when transporting raw materials or delivering finished products from one location to another. These materials and products may be transported by land, sea or by air.

Shipping costs vary depending on the company's sales and production volumes. These costs typically increase with higher production and sales volumes and decrease with lower sales and production volumes. A strong supply chain can reduce overall costs and increase distribution efficiencies.

Production supplies

Production supplies are the indirect raw materials needed during the manufacturing or assembly process. One example is machine oil, which is challenging to measure based on how much or how often the company uses the machines. Since the cost of machine oil varies with production volume, it's a variable cost.

Billable wages

This refers to the amount of money paid to employees who work on an hourly schedule. This contrasts with salaries, which are fixed amounts regardless of how many hours employees work.

Billable wages are a variable cost because they change based on the number of employees, the number of hours each employee works and the total number of hours the company or organization allows employees to work.

Credit card transaction fees

These fees apply to a business that accepts credit cards as a method of payment from customers. Here, the variable cost is the unpredictable amount of transaction fees each month as opposed to a fixed monthly fee. For example, a company may use a third-party organization to process its credit card sales, and pay a percentage of those sales to the company for its services.

Related: What Is Cost Behavior?

Example of total variable cost calculation

The total variable cost can be determined by calculating the cost per unit. Here's an example of a manufacturing company that produces hair dryers:

A company receives an order for 100 hair dryers. When estimating the total variable cost that the company spends to produce 100 units, it calculates the variable cost of producing each hair dryer. To calculate the variable cost, the project manager uses these figures:

• Cost of direct materials (heating element, fan, motor, heat shield, switches, polarized plug) per unit: $8

• Cost of direct labor (automated equipment and manual labor) per unit: $4

• Fixed costs (overhead) per unit: $2

Based on these figures, the cost of producing one unit is:

$8 + $4 + $2 = $14

Next, to calculate total variable cost, the project manager uses this formula:

Total output quantity x Variable cost per unit = Total variable cost

Applying the formula for total variable cost, the project manager determines the company invests $1,400 in materials and labor to produce 100 hair dryers as shown:

100 x $14 = $1,400

Read more: How To Calculate Total Variable Cost

Why is it important to determine variable costs?

Determining variable costs is important because it can help a company:

• Make informed business decisions: A high proportion of variable costs may enable a company to continue operating even if its sales volume is relatively low. A high proportion of fixed costs often means that the business maintains a high volume of sales to remain financially viable.

• Monitor variable expenses: Although the fixed costs associated with running a business remain relatively the same regardless of production output, variable costs always increase the total variable cost as production increases.

• Set appropriate sales targets: Rising expenses associated with variable costs aren't a negative indicator. It's always necessary to ramp up production to achieve higher sales targets, which can entail additional costs.

• Prevent overspending on materials or underpricing the cost per unit: It's important to ensure that revenue increases at a higher rate than expenses. For example, if a company reports a volume increase of 8%, but the amount of sales increases by only 5% over the same period, then each product sold is most likely underpriced.

• Reduce manufacturing costs: It's beneficial for companies to reduce the costs of manufacturing their products to ensure profitability. Therefore, many managers monitor profitability by dividing the variable costs by the total revenue to determine the costs as a percentage of the sales.

• Find your break-even point: Many companies consider variable costs when making profit projections or calculating break-even points for specific ventures or projects. Some expenses may fluctuate according to a corresponding change in output, which may cause inconsistencies on your balance sheet.

• Analyze fixed costs to reduce unnecessary expenses: It's also worth noting that many products have variable components and fixed components. Management salaries, for example, aren't usually dependent on the number of units produced.

• Calculate more predictable profit margins: Companies that consistently have a higher percentage of variable costs compared to fixed costs may have more consistent costs per product. They could have more predictable profit margins than companies with relatively fewer variable costs.

• Manage and reduce variable costs to increase profitability: The success of a company often depends on the ability to make educated predictions for how the business venture is affected by different operating conditions. One of the most important factors in making such predictions is determining the proportion of fixed costs to variable costs.