A variable cost (VC) 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 costs are part of the total costs of a business.
Variable Cost Examples
Depreciation
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 expense 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. In this case 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.
Advertising
Is advertising a variable cost? – Advertising can vary with the level of selling activity so can be variable costs. To illustrate 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 expense varies directly in proportion to the selling activity and is regarded as variable.
In contrast if 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.
Sales Commission
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.
Direct Labor
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 Effect of Variable Cost on Gross Profit
Variable costs are a major factor in determining the gross profit and the gross profit percentage of a business. For a product the gross profit percentage is given by the following formula
Gross profit % = (Selling price - Variable cost) / Selling price
As can be seen the higher the variable cost the lower the gross profit percentage.
The Effect of Variable Cost on Break Even Point
Additionally the break even point of the business is dependent on the gross profit percentage. The break even sales is given by the following formula.
Break Even Sales = Fixed Costs / Gross profit %
Using both the formulas above we can see that as the variable costs increase, the gross profit percentage reduces, which results in a higher sales volume required to reach the break even point.
To illustrate, suppose a business is running at a loss and sales are falling. The initial reaction might be to try and increase sales volume. However, an alternative 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 VC per unit will directly affect the price which a business is able to sell its product and make a profit. The VC 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 VC will increase as the number of units produced increases.
To illustrate suppose a business has a VC per unit of 5.00 and produces 1,000 units. In this case the total VC is calculated as follows.
Variable cost = Variable cost per unit x Units Variable cost = 5.00 x 1,000 = 5,000
If however production increases to 5,000 units the VC per unit is still 5.00 and the total VC is now as follows.
Variable cost = Variable cost per unit x Units Variable cost = 5.00 x 5,000 = 25,000
As can be seen although the VC per unit remains fixed the total VC increases with production. In 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 Double Entry Bookkeeping. 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 degree from Loughborough University.