If you’re here to better understand the term ‘Variable Costs’, you’re at the right place. Knowing what it means will help you to scale your business. This article helps you to understand exactly that and takes you through how to calculate it and examples to illustrate the term for you. For more questions related to accounting for your business, feel free to drop us a chat to talk to our helpful accounting experts.
What are variable costs?
Variable costs are expenses that vary depending on the volume of goods or services your business produces. They increase as production volume increases and vice versa. Sometimes, they are also called “unit-level costs” as they vary when the number of units produced changes.
Variable costs are usually opposed to fixed costs which stay the same regardless of changes in production volume and have to be paid even when a company does not sell anything.
The most common fixed costs are rent and insurance that have to be paid regularly no matter what. Variable costs together with fixed costs, make total costs, a.k.a. the total amount of expenses a business has to pay.
You can estimate the variable costs of your business when you calculate how much money your company will save when it puts production of your goods and services on hold. This number will be the variable costs.
Examples of variable costs
Every operating business has variable costs to pay, however they are different for every company depending on what exactly it produces. The most common examples of variable costs are:
- Direct labor - hours of work associated with making one unit of production or providing a service;
- Raw materials needed to make one unit of production or provide a service;
- Transaction fees associated with various payments needed to create a product or provide a service;
- Commissions if a company’s employees are rewarded for sales they make;
- Shipping if products are delivered to shops, warehouses, or customers;
- Utilities if making a product/service requires power, water, or gas.
Let’s take a look at an example:
Bob owns an Italian restaurant, selling pizza and pasta. These items are the product he sells. Bob has to pay rent and insurance monthly no matter how many dishes he serves and whether anything gets served at all, so these are his fixed costs. However Bob also needs to buy cooking ingredients, pay his staff their hourly wages, and cover electric and water bills. All of these vary depending on how many guests come to the restaurant, how much food they order and how extensively his kitchen is used. Moreover, Bob has recently introduced a delivery service and therefore has to pay for gas and car repair which also depend on the volume of call-in orders. All of these are his variable costs.
Diane is a stylist who sells her consulting services. She works from home and does not need an office. However, she runs a website that advertises her services. She has to pay for website hosting no matter how many consultations she provides, so for her it is a fixed cost. Diane has to go to various boutiques and fashion shows to help her clients pick the best outfits. She also offers phone consultations. The more clients she has, the bigger are her travel expenses and phone bills. In Diane’s case, these are her variable costs.
What is the variable cost formula (per unit)?
Variable cost per unit can be calculated using a simple procedure:
- Estimate your total variable costs for a certain period of time. If unknown, they can be calculated by subtracting fixed costs from total costs for this period;
- Identify how many units of production were produced over a certain period;
- Divide total variable costs (1) by number of units (2). The resulting number will be your variable cost per unit.
Variable cost per unit = Total variable costs / Number of units produced
Imagine your business produces and sells T-shirts. You know that in July, your total variable costs were 3,000 USD; this included your staff wages, fabric and electricity required by your workshop’s sewing machines. In July, you made 100 T-shirts.
Variable cost per unit = Total Variable cost / Number of units
Variable cost per unit = 3000 / 100
Variable cost per unit = 30 USD
It means that in July, your variable cost per unit was 30 USD. At the same time, your variable costs in August were 3,500 USD while you made the same 100 T-shirts. Calculations show that in August, your variable cost per unit was 3500 / 100 = 35 USD which is slightly more than in the previous month, yet the production volume did not change.
After checking your expenses, you find out that while you spent the same amount of money on salaries and fabric, your electric bill was higher than it was supposed to be. This indicates that in August, your use of electricity was not rational and could be improved.
Why should I know the variable costs for my business?
It is important to keep track of variable costs as they show where a company’s money goes, and whether the business is managed efficiently. If a company wants to have bigger profits, one of the ways to achieve this goal is to cut costs. Fixed costs are often difficult to reduce: decreasing rent may imply moving to a cheaper location with a smaller client base, and cutting salaries may result in poor quality of work. Variable costs, on the other hand, can be optimized to help a company spend less. Ways of reducing variable costs include purchasing cheaper raw materials, working with banks that charge lower transaction fees, outsourcing some of the company's services for a lower price etc.
If you have more questions like calculating variable costs on multiple products, have a chat with our accountants. By the way, we can help you start your company in the UK too.