There’s one frustrating truth that every business grapples with early on in its growth: more money, more problems.
It seems counter-intuitive – if sales and revenue are increasing, isn’t that a good thing? How are higher profits a potential problem?
Put simply, it all comes down to the more you sell, the more money you have to spend. These include marketing and sales campaigns to reach more customers, the cost of producing more goods, and the time and money spent developing new products.
This sales-to-spend ratio, known as variable cost, should be understood by any business owner, but online advisory lists and action plans often assume that readers have an intrinsic knowledge of this concept rather than providing a working definition.
In this article, we’re going to remove the confusion about variable costs: Here’s what you need to know about variable costs, how to calculate them, and why they matter.
What are variable costs?
Variable cost is the sum of all labor and material costs required to make one unit of your product. Your total variable cost is equal to the variable cost per unit multiplied by the number of units produced. Your average variable cost is your total variable cost divided by the number of units produced.
Let’s examine each of these components in more detail.
Variable cost per unit
The variable unit cost is the amount of labor, materials, and other resources that it takes to make your product. For example, if your company sells kitchen knife sets for $ 300 but each set needs $ 200 to build, test, package, and market, your unit variable cost is $ 200.
Number of units produced
The number of units produced is exactly what you might expect – it’s the total number of items your company produces. So, in our knife example above, if you made and sold 100 sets of knives, your total number of units produced is 100, each with a variable price of $ 200 and a potential profit of $ 100.
Variable cost formula
To calculate the variable cost, multiply the cost of making one unit of your product by the total number of products you made. This formula looks like this: Total variable cost = cost per unit x total number of units.
Variable costs deserve the name because they can go up and down as you make more or less of your product. The more units you sell, the more money you make, but some of that money has to be paid to produce more units. So you have to produce More Units to actually make a profit.
And since each unit requires a certain amount of resources, increasing the number of units increases the variable costs required to manufacture them.
However, variable costs are not a “problem” but rather a necessary evil. They play a role in several accounting tasks, and both yours total variable costs and average variable costs are calculated separately.
Variable total costs
Your total variable costs are the sum of all variable costs associated with each and every product you develop. Calculate the total variable cost by multiplying the cost of a unit of your product by the number of products you have developed.
For example, if one unit of your product was $ 60 to make and you made 20 units, your total variable cost would be $ 60 x $ 20, or $ 1,200.
Average variable cost
Your average variable cost uses your total variable cost to determine how much it costs, on average, to make one unit of your product. You can calculate it using the following formula.
Total variable costs vs. average variable costs
If the average unit variable cost is calculated using your total variable cost, don’t you know how much a unit of your product cost to develop? Can’t you work backwards and simply divide your total variable cost by the number of units you have? Not necessarily.
While the total variable cost shows how much you are paying to develop each unit of your product, you may also need to consider products with different variable cost per unit. This is where the average variable cost comes into play.
For example, if you have 10 units of Product A at a variable cost of $ 60 / unit and 15 units of Product B at a variable cost of $ 30 / unit, you have two different variable costs – $ 60 and $ 30. Your average variable costs reduce these two variable costs to a manageable number.
In the example above, you can find your average variable cost by adding and dividing the total variable cost of product A ($ 60 x 10 units or € 600) and the total variable cost of product B (€ 30 x 15 units or € 450) this sum by the total number of units produced (10 + 15 or 25).
Your average variable cost is ($ 600 + $ 450) ÷ 25, or, $ 42 per unit.
Variable vs. fixed costs
The opposite of variable costs? Fixed costs. Fixed costs are costs that do not change with the number of products you produce.
Some common fixed costs include renting or leasing a building, utility bills, website hosting, business loan repayments, and property taxes.
Worthless? These costs are not static – That means your rent can increase from year to year. Instead, they just remain pinned on how the product is made.
To calculate the average fixed cost, use this formula:
Both variable and fixed costs are critical to getting a complete picture of how much an item costs to make – and how much profit remains after each sale.
How high is the variable expense ratio?
The variable expense ratio enables companies to determine the relationship between variable costs and net sales. The calculation of this metric helps you to take into account both the increasing sales and the increasing production costs so that the company can continue to grow steadily.
To calculate the variable cost ratio, use this formula:
Let’s put it into action. If you sell an item for $ 200 (net sales) but cost $ 20 to make (variable cost), divide $ 20 by $ 200 to get 0.1. Multiply by 100 and your variable expense ratio is 10%. This means that for every sale of an item, you will get a return of 90%, with 10% for the variable costs.
The combination of variable and fixed costs can help you achieve your Break-even point – the point at which the manufacture and sale of goods are zeroed by the combination of variable and fixed costs.
Look again at our example above. If your variable cost is $ 20 for a $ 200 item and your fixed cost is $ 100, your total cost is now 60% of the item’s sales value, so you have 40%.
Expressed in a simple way? The higher your total expense ratio, the lower your potential profit. If that number turns negative, you have broken breakeven and are losing money on every sale.
So what counts as variable costs for the company?
The most common variable costs include physical materials, manufacturing equipment, sales commissions, staff salaries, credit card fees, online payment partners, and packaging / shipping charges.
Examples of variable costs
- Physical materials
- Production equipment
- Sales commissions
- Staff salaries
- Credit card fees
- Online payment partner
- Packing and shipping costs
Let’s examine each one in more detail.
These can be parts, fabrics, and even food ingredients that are required to make your end product.
If you are automating certain parts of your product development, you may need to invest in more automation equipment or software as your product line grows.
The more products your company sells, the more commission you might pay to your sales reps for attracting customers.
The more products you create, the more employees you may need, which also means a higher payroll.
Credit card fees
Businesses that receive credit card payments from their customers face higher transaction fees as they provide more services.
Online payment partner
Apps like PayPal usually charge companies per transaction so that customers can bill purchases through the app. The more orders you receive, the more you pay to the app.
Packing and shipping costs
You may have to pay per unit to package and ship your product, and therefore these costs will vary with more or fewer units shipped.
Expect the unexpected
While variable cost, variable total cost, average variable cost, and the variable cost ratio often seem complicated on the surface, these terms are simple ways to represent the changing cost of producing new items as the business grows.
Understanding the nature of these costs and how they affect your current and projected sales can help you prepare for evolving market forces and reduce the impact of variable costs on your bottom line.