Variable Costs: Understanding the Key Factor in Business Expenses

An employee’s hourly wages are a variable cost; however, that employee was promoted last year. The current variable cost will be higher than before; the average variable cost will remain something in between. Raw materials are the direct goods purchased that are eventually turned into a final product. If the athletic brand doesn’t make the shoes, it won’t incur the cost of leather, synthetic mesh, canvas, or other raw materials. In general, a company should spend roughly the same amount on raw materials for every unit produced assuming no major differences in manufacturing one unit versus another. Average fixed costs are found by dividing total fixed costs by output.

  • Average total costs are a key cost in the theory of the firm because they indicate how efficiently scarce resources are being used.
  • If the company produces 500 units, its variable cost will be $1,000.
  • Both variable costs and fixed costs play important role in bookkeeping tasks.
  • No matter how confident you feel in your business’s budget, it never hurts to have another set of eyes.
  • That said, labour completed by salaried employees is a fixed cost because it is the same every pay period, regardless of hours worked.

Consider asking your utility providers for “budget billing,” where you pay the same amount each month to reduce the variability of your utility expenses. Look for ways to reduce distribution costs from your suppliers and to your customers, like packaging improvements and alternative distribution channels. It is important to understand the difference between gross and net profit. Knowing the gross profit margin, net profit margin and average rate of return is essential when making business decisions. Investors can come up with a rough estimate of DOL by dividing the change in a company’s operating profit by the change in its sales revenue.

What Is the Formula for Total Variable Cost?

Using the calculation above, we’ve determined that you’re making $21.90 on each pair of shoes sold. Freight is another expense not included in the cost of goods sold, but it increases or decreases based on production. One of the challenges business owners face is accurately accounting for variable costs. Accounting for variable costs is easiest when using accounting software, as many of the costs involved are automatically recorded when purchase orders are processed or materials received. Reducing energy use can help manage variable costs, particularly in energy-intensive industries. This could involve adopting energy-efficient technology, improving insulation or adjusting operating hours to take advantage of off-peak power rates.

  • Use the highest average from the last few years to estimate the next year.
  • Because these costs can vary based on production levels, manufacturing supplies are always considered a variable cost.
  • A professional accountant can offer an objective analysis of your budget and potentially help you save even more on overhead costs.
  • In other words, every additional product sold costs the business money.

If you need to cut your overhead costs, the first step is setting aside time to comb through every single expense you have and understand exactly how much you’re spending. Once you’ve taken that step, you can start to assess what’s necessary, what can be reduced and what should be eliminated entirely. For example, let’s say that Company ABC has a lease of $10,000 a month on its production facility and produces 1,000 mugs per month. If it produces 10,000 mugs a month, the fixed cost of the lease goes down to the tune of $1 per mug.

Are marginal costs fixed or variable costs?

“Print out a profit and loss statement that spans the past 12 months,” said Claudio Conte, CPA and co-founder of Bullstrap. If you budgeted wisely and ended up with a little extra — outside your cushion — at the end of the year, deposit that money in a savings account to help deal with price spikes. Even better, deposit excess funds at the end of each month so you’ll have an emergency fund to dip into if March is colder or September is warmer than expected. Variable costs change every day, and thus every month and every year. Awareness using Stampli Card doesn’t stop at the time spending occurs.

Understanding which costs are variable and which costs are fixed are important to business decision-making. Variable costs play a key role in determining the total cost of an organization’s production budget. These costs vary in direct proportion to the level of production, and therefore can have a major impact on profitability. Managing variable costs carefully can greatly reduce business expenses and improve profitability.


And that can considerably offset any money you save by cutting costs. Variable cost and average variable cost may not always be equal due to price increase or pricing discounts. Consider the variable cost of a project that has been worked on for years.

They are not time-bound and can potentially decrease with efficiency and scale. Understanding these features is crucial for any business to plan and manage their finances effectively. In a manufacturing company, for example, the cost of raw materials increases when more units are produced and decreases when fewer units are produced. As mentioned, variable costs are dependent on production output or sales. Fixed costs, on the other hand, are independent and remain constant regardless of production levels. The total expenses incurred during any corporate activity consist of variable and fixed costs.

Measuring Operating Leverage

But companies with a lot of costs tied up in machinery, plants, real estate and distribution networks can’t easily cut expenses to adjust to a change in demand. So, if there is a downturn in the economy, earnings don’t just fall, they can plummet. Go back and calculate how much you’ve spent on variable expenses over the past several years.

Join us as we explore how businesses can manage variable costs more effectively. If companies ramp up production to meet demand, their variable costs will increase as well. If these costs increase at a rate that exceeds the profits generated from new units produced, it may not make sense to expand. A company in such a case will need to evaluate why it cannot achieve economies of scale. In economies of scale, variable costs as a percentage of overall cost per unit decrease as the scale of production ramps up.

Outsourcing some positions to contractors can also lower your overall labor costs. Understanding the different types of costs can help a business owner budget, manage costs, and make informed decisions about their operations. Different strategies can be taken for managing each type of cost in order to maximize the efficiency of the business. Above that amount, they cost you more, depending on how much revenue you earn.

During the 1990s, investors marveled at the nature of its software business. The company spent tens of millions of dollars to develop each of its digital delivery and storage software programs. But thanks to the internet, Inktomi’s software could be distributed to customers at almost no cost. After its fixed development costs were recovered, each additional sale was almost pure profit.

However, these efforts require a certain initial expenditure or investment. At the same time, well-managed sustainability initiatives can lead to a decrease in variable costs in the long run, hence potentially increasing profitability. In each of these cases, a thorough understanding of variable costs aids in making informed, strategic decisions that can significantly impact a business’s bottom line. This is why managing variable costs is not just a matter of monitoring expenses, but a key function of overall business management.