Variable Cost Definition, Factors, Formula, and Applications

Careful analysis of cost behavior and activity drivers is needed to accurately separate costs. For businesses, setting the right price for products or services is a balancing act. Kristen Slavin is a CPA with 16 years of experience, specializing in accounting, bookkeeping, and tax services for small businesses. A member of the CPA Association of BC, she also holds a Master’s Degree in Business Administration from Simon Fraser University.

Exercises and Examples for Variable Costs

• To better explain this concept and differentiate variable and fixed costs, we’ll use a few examples to help you understand how they may apply to your industry.
• This means that service industry businesses are more vulnerable to competition since startup costs are much lower than other types of businesses.
• Depending on how your sales or production rates are going, your variable costs can rise or fall—hence the name.
• Lastly, variable cost analysis is useful when determining your company’s expense structure.
• The commission rate per unit doesn’t change, but as sales volume rises, total commissions increase.

Therefore, total variable costs can be calculated by multiplying the total quantity of output by the unit variable cost. If you pay based on billable hours, commissions, or piece-rate labor rates (when workers are paid based on how many units they produce), these would be considered variable costs. The same goes for staffing more hourly wage workers (or having them work more hours) to meet increased production goals. Total contribution is the difference between total revenue and total variable costs. A positive value of total contribution means that the business can cover its fixed cost and generate some profit. The commission rate per unit doesn’t change, but as sales volume rises, total commissions increase.

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While COGS can also include fixed costs, such as overhead, it is generally considered a variable cost. For example, the chair company gets an order for 30 chairs for a total selling price of $2,400. To find variable cost per unit, we add the cost per unit in materials ($25) and direct labor costs ($25), and multiply it by our total quantity of output (how many chairs are produced for the order). This means that variable costing income statements will show higher operating income at higher production volumes, since fixed operating costs are treated as period expenses rather than product costs. For a business which produces clothing, variable cost would include the direct material, i.e., cloth, and the direct labor.

Variable Costing and Income Statement Presentation

If the chair company knows it costs $50 per unit in variable costs to produce a single chair, it wouldn’t make sense to price the chair any lower than $51, since you would lose money on each sale. Direct labor is sometimes a variable cost depending on how you staff your production area. Odds are, your production area needs a minimum amount of staff to operate regardless of how many units you produce—this is a fixed cost. But if you need more staff (or need staff to work more hours) to fulfill an order, paying wages for these labor increases would be considered a variable cost.

Variable Costs vs. Fixed Costs

For instance, a manufacturer that boosts production from 1,000 to 2,000 units will incur higher variable costs for materials and labour (paid by the hour), while fixed overheads like rent remain unchanged. Understanding the behaviour of variable vs. fixed costs is essential for apt budgeting, pricing decisions, and measuring operational efficiency. Managers can control variable costs more easily in the short-run by adjusting output. For example, the cost of raw materials used in producing output is a variable cost. For furniture manufacturer, wood is the raw material used in making furniture items.

• However, if you pay commissions for every unit sold on top of a salary, they would be variable costs.
• In short, fixed costs are more risky, generate a greater degree of leverage, and leave the company with greater upside potential.
• The cost of wood is a variable cost as it varies directly with the change in the production output of furniture items.
• This means they have huge startup costs, but are much less vulnerable to competition once they’re up and running.
• Costs are fixed for a set level of production or consumption and become variable after this production level is exceeded.
• In conclusion, the variable cost in the production process is a cost that only increases when the quantity of output increases.

Moreover, understanding how changes in variable costs can impact profitability allows companies to make informed decisions about scaling up or down. For instance, purchasing raw materials in bulk might result in discounts, thereby reducing the cost per unit. Similarly, streamlining production processes can also lead to decreased costs per item. This, in turn, will raise the cost per unit, leading to higher variable costs for businesses reliant on that material. In accordance with the accounting standards for external financial reporting, the cost of inventory must include all costs used to prepare the inventory for its intended use.

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As you can see, variable costing gives managers key insights into profit drivers. These costs, which change with production volume, encompass a wide range of expenses beyond just physical items. However, it’s essential to recognize that economies of scale can plateau.

Production supplies and equipment refers to any necessary supplies or equipment that fluctuate with your output level. For the chair company, an example would be oil for meaning of variable costing machines involved in the woodworking process. If the company makes more chairs, they’ll need more machine oil, making this a variable cost. Restaurants, on the other hand, tend to have much higher variable costs, since they depend so heavily on labor. This means that service industry businesses are more vulnerable to competition since startup costs are much lower than other types of businesses. The raw materials are the inventory of unprocessed materials purchased to produce a final product.