Variable Cost: Definition, Formula, and Examples

However, anything above this has limitless potential for yielding benefits for the company. Therefore, leverage rewards the company for not choosing variable costs as long as the company can produce enough output. Therefore, a company can use average variable costing to analyze the most efficient point of manufacturing by calculating when to shut down production in the short term and even when to shut down a plant. 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. If your company offers shipping to customers, you’ll need to consider packaging and shipping among your other variable costs. Since you’ll only need to pay for packaging and shipping if/when you make a sale for delivery, it’s considered a variable cost—even if the price of shipping remains the same over time.

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One of the primary limitations of variable costs is the difficulty in predicting sudden shifts. By constantly evaluating and adjusting resource allocation based on variable cost data, businesses can ensure they’re operating efficiently and maximizing returns. Because Variable Costs are tied to production, they are usually thought of as a constant amount expensed per unit produced.

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In general, it can often be specifically calculated as the sum of the types of variable costs discussed below. Variable costs may need to be allocated across goods if they are incurred in batches (i.e. 100 pounds of raw materials are purchased to manufacture 10,000 finished goods). Variable costs are not inherently good or bad—they are a reality of providing any kind of product or service to your customers.

Utility Costs

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It follows the underlying guidelines in accounting – the matching principle. Absorption costing better upholds the matching principle, which requires expenses to be reported meaning of variable costing in the same period as the revenue generated by the expenses. As the production output of cakes increases, the bakery’s variable costs also increase. The company faces the risk of loss if it produces less than 20,000 units.

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PQR is a chocolate factory and has the costs, sales, and production information as per the below template. For example, if a spike in demand for a particular raw material occurs due to global shortages, the cost to purchase that material will increase. Variable costs are usually viewed as short-term costs as they can be adjusted quickly. For example, if a company is having cash flow issues, it may immediately decide to alter production to not incur these costs. To find out more on costs, budgeting, accounting and other core financial knowledge, look at our Finance for the Non-Financial Manager e-learning course.

• The contribution margin is a key input into the breakeven calculation, which is used to derive the sales level at which a business generates a zero profit.
• Managing these factors diligently allows companies to boost margins by reducing variable cost per unit.
• This is a variable cost since it depends on how many sales you make (and what methods your customers use to pay).
• In addition, variable costs are necessary to determine sale targets for a specific profit target.
• It is the contrary scenario from fixed costs where, those costs would be incurred irrespective of the output of the organization.
• These costs have a mix of costs tied to each unit of production and a fixed cost which will be incurred regardless of production volume.

Variable Costing vs Absorption Costing: A Comparative Analysis

You should strive to keep variable cost per unit as low as possible since this will result in more profit per unit. But if your total variable costs are rising, you are producing more units—hopefully at a net profit. Salaries are fixed costs because they don’t vary based on production or revenue. However, if you pay commissions for every unit sold on top of a salary, they would be variable costs. Lastly, variable cost analysis is useful when determining your company’s expense structure.

Formula and Calculation of Variable Costs

• Tracking variable manufacturing overheads ensures companies know the true cost of increased production capacity.
• Since fixed costs are more challenging to bring down (for example, reducing rent may entail the company moving to a cheaper location), most businesses seek to reduce their variable costs.
• Our work has been directly cited by organizations including Entrepreneur, Business Insider, Investopedia, Forbes, CNBC, and many others.
• Variable costing poorly upholds the matching principle, as related expenses are not recognized in the same period as related revenue.
• Efficient management of variable costs is a cornerstone of successful business operations.
• It encompasses all necessary resources, including labor, materials, marketing, and anything else needed to sell the product.
• Variable costing excludes fixed or absorption costs, and hence profit is most likely to increase owing to the money made through the sale of the additional items.

Balancing these strategies while addressing complexities in cost identification ensures businesses make informed choices, optimizing their performance and sustaining success. Sometimes, replacing a high-cost material with a more affordable alternative without compromising on quality can lead to substantial savings. Lean management focuses on eliminating waste in all forms from the production process.