Variable Cost Definition
A variable cost is a cost which will vary in direct proportion to any production or selling activity.
The only question to ask is does the cost vary if the business changes its level of production or selling activity, if the answer is yes then the cost is a variable cost.
Variable Cost Examples
Is depreciation a variable cost? – Depreciation can be a variable cost. For example a machine is purchased for 25,000 and has a useful life of 10,000 production hours. The variable cost of using the machine is 2.50 per production hour.
If however, the machine was depreciated over a useful life of 5 years, the cost per year would be 5,000 and the cost would be regarded as fixed as it does not vary with the level of production output.
The nature of it being variable has been determined by the choice of method of depreciation.
Is advertising a variable cost? – Advertising can vary with the level of selling activity so can be a variable cost. For example if an advert is placed online on a cost per action basis, and the action needed is a sale, then each time a sale is made an advertising cost is incurred. The advertising cost varies directly in proportion to the selling activity and is regarded as variable.
If however, the advert is placed in a magazine at a fixed cost, it is independent of the business activity and would be regarded as a fixed cost.
Is sales commission a variable cost? – Sales commissions do vary with the level of activity of a business and so are considered to be variable costs.
Is direct labor a variable cost? – direct labor tends to vary with the level of production and so is a variable cost. There are limits in that employees cannot be removed for every small change in production activity, but it is normal to assume direct labor is variable.
Importance of Variable Cost Identification
It is important for a business to identify which of its costs are variable for a number of reasons.
The variable cost is a major factor in determining the gross profit and the gross profit percentage of a business, which represents its real income.
Break even point
The break even point of the business is dependent in its gross profit percentage, which in turn depends on the variable costs of the business.
The break even sales is given by the formula, Break Even Sales = Fixed Costs / Gross profit %. For a given fixed cost, the higher the variable costs, the lower the gross profit percentage, and the higher the sales needed to break even. If a business is running at a loss and sales are falling, one method of correcting the situation is to bring down the break even point by reducing the variable costs and increasing the gross profit percentage.
Variable Costs per Unit
The variable cost per unit will directly affect the price which a business is able to sell its product and make a profit. The variable cost per unit needs to be a low as possible. Variable costs per unit remain the same irrespective of how many units are produced. Because of this the total variable cost will increase as the number of units produced increases.
For example, if a business has a variable cost per unit of 5.00 and produces 1,000 units, then the total variable cost is 1,000 x 5.00 = 5,000. However, if production increases to 5,000 units the variable cost per unit is still 5.00 and the total variable cost is now 5,000 x 5.00 = 25,000
By contrast fixed costs do not vary with the level of production or selling activity within the business.
About the Author
Chartered accountant Michael Brown is the founder and CEO of Plan Projections. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a BSc from Loughborough University.