Definition:
A variable cost is a direct cost that the total costs or expenses change when the total volume of goods and services that the company produces. A company’s total variable cost increases and decreases with the amount of production, but the variable cost per unit is not changing.
If production goes up, variable costs increase; if production is slowed down, variable costs decrease. Some examples of variable costs include the cost of raw materials and packaging.
Formula:
To calculate the variable cost, we can use the following formula,
Total Variable Costs = Total Quantity of Output * Variable Cost Per Unit
And to calculate the variable cost per unit can be calculated as follow,
Variable cost per unit = Total Variable Costs / Total Quantity of Output
Variable Cost and its comparison to Fixed cost
A company’s main costs when producing goods and services are variable and fixed costs.
A variable cost varies with the number of goods and services produced, whereas a fixed cost remains the same no matter how much output the company produces.
Fixed cost remains the same even when no goods or services are produced by the company I.e. there is no way a company can avoid fixed costs.
A company must pay these expenses independently of any specific business activity. Some examples of fixed costs are depreciation, rent, insurance, and indirect labor.
| Fixed costs | Variable costs | |
| Definition | Costs that don’t change the production volume | Costs that vary or change in production volume |
| Nature | Fixed costs are time-related, as they remain the same for some time | Variable costs are volume-related, as they change with the changes in production volume |
| When production increases or decreases | The total fixed cost stays the same | Total variable cost increase/decrease |
| Example | Rental expenses, advertising expenses, depreciation expenses, insurance expenses, etc. | Direct material (sugar, egg, wood, cement), direct labor ( salary or wags) |
Examples of Variable Costs:
- Direct materials: These are the raw materials that go into making a product. As the number of produced goods increases, the number of raw materials also required increases.
- Piece labor rate: This is the amount paid to workers for each unit completed. The higher the production, the higher the labor wages, and vice versa in the case of lower production.
- Production supplies: These costs vary with the production volume; for example, machinery oil is consumed based on the company’s machinery used to produce goods and services.
- Commissions: Salespeople are paid commissions over their salaries only if they sell a product or service.
- Freight cost: A shipping cost is incurred by the company when it sells and ships a product.
- Billable staff wages: If a company pays its workers based on the number of hours worked, it is a variable cost. However, if they are paid monthly salaries, then it will be a fixed cost.
Moreover, the variable cost can also be explained through a numeric example.
For instance, a bakery incurs 15 dollars to bake a cake, 5 dollars for the material such as sugar, milk, and flour, and 10 dollars for the direct labor involved in baking one cake.
However, the variable cost changes as the number of cakes vary. If the production output of cakes increases, the variable costs also increase, and if the production of cakes decreases, variable costs decrease.
The variable costs are zero when the bakery makes zero cakes since no sugar, milk, or flour is required.
Sometimes, a company can increase its profits by decreasing its total costs. Still, since fixed costs are challenging to bring down, companies usually reduce their variable costs, for example, reducing their direct material cost by contracting with a cheaper supplier.
Here are the Example of Variable Costs for Airlines
- Fuel: Airlines spend significant amounts of money on fuel costs, which are highly affected by fluctuations in the price of oil. This cost can vary significantly from day to day and year to year, depending on the market conditions.
- Personnel: Airlines have to pay for personnel such as pilots and flight attendants, as well as ground staff like customer service agents and baggage handlers. Salaries and benefits make up a large part of an airline’s overhead expenses.
- Aircraft Leasing Costs: Many airlines lease aircraft rather than purchase them outright, adding additional costs to operating an airline.
- Maintenance & Repair: To keep aircraft safe, qualified technicians must regularly maintain and repair, adding variable costs for airlines.
- Airport Fees/Landing Rights: Landing at airports requires payment to the airport authority and landing rights fees in some instances where foreign airlines wish to land in another country’s airports.
- Cargo Fees: Air cargo is a lucrative sector for airlines due to its speed and flexibility, but it comes with fees associated with storing, handling, and transporting cargo items that need to be taken into account when calculating variable costs for the airline industry.
- Advertising & Promotions: Airlines often invest significant amounts of money into marketing campaigns designed to increase bookings or boost passenger loyalty programs such as frequent flyer miles programs or other loyalty schemes connected with the airline’s brand awareness strategy.
- Marketing/Sales Commissions: Travel agencies charge commission fees for selling tickets through their services. At the same time, other sales channels are also included in this list, such as online travel booking sites, which also add a layer of additional costs related to selling tickets through these channels.
- Navigational Services & Weather Services: For planes to reach their destinations safely and efficiently, navigational services are required alongside weather services to navigate potential hazards en route, both of which come with added expense, although they may be less volatile than some others on our list.
- Insurance: All carriers require liability insurance – including passenger insurance – so that if any mishaps occur, a page is covered in case of legal action. This type of insurance is essential for ensuring passenger safety but does come at a high cost.
Financial Statement Analysis:
In determining variable costs, different types of financial statements are used. They can be simple or complicated to identify, depending on the type of statement used.
In a variable costing income statement, variable costs are clearly labeled but not in an absorption costing income statement.
Defining variable costs is very easy if a company uses a variable costing income statement.
This type of income statement is usually used by management to evaluate and measure the costs of a business. Variable costs are clearly labeled on the information and under the sales revenue.
A line item on the income statement, the cost of goods sold, includes direct labor and direct material cost, which is summed up with another line item, like variable selling expenses.
The sum of these two costs is the total variable cost which is then deducted from total revenue to arrive at the total contribution margin, and further fixed costs are lessened to arrive at the net profit.
What are Variable Costs of Production?
Variable costs are those costs that fluctuate according to how much output a company produces.
They may include materials, parts, and labor used to manufacture products or services.
The production process may also include variable expenses such as shipping and packaging supplies, marketing expenses, and electricity consumed in the production process.
Materials used in production are one of the more common types of the variable cost related to making products or providing services.
Materials can range from raw materials such as steel, wood, or plastic for manufacturing businesses to office supplies for service providers such as lawyers and accountants.
While some companies use a straight-line cost method where all material costs remain fixed regardless of production level, others will see their costs increase when they increase their output levels.
Labor is usually considered a variable cost because it changes depending on the number of people working at any given time, their wage rate, and the hours they work.
As production increases, so too may the wages associated with these additional workers and overtime pay.
Should extra hours be required to produce more goods or services?
The cost of utilities like electricity is also accounted for under variable expenses. It can vary drastically depending on how much power a company needs to use during a specific period or for particular projects.
A business using large-scale machinery will likely require more significant amounts of electricity than one using minuscule tools.
Transporting goods to customers is another variable cost since it can be difficult to predict exactly how far away from the original point of origin goods will be shipped on any given day and, thus, what your total shipping bill may amount to by day’s end.
Variable costs also include:
- Packaging materials like boxes, wrapping paper, and even tape are needed for shipment purposes.
- Marketing expenses, including commission payments for sales staff.
- Credit card fees paid by customers.
- Advertising materials are chosen each day.
- Promotional items like calendars are distributed throughout the year.
- Office supplies.
- Franchise fees, among other things, depending on a business’s daily activity levels.
What are the components of variable cost?
Variable costs vary with the number of goods or services produced. Variable costs include raw materials, direct labor, commissions, and transportation costs.
Raw materials are the materials needed to make a product or service, such as wood for furniture or oil for cars.
Direct labor refers to the wages paid to employees directly involved in producing a good or service.
Commissions refer to payments made when sales of a product or service occur and usually comprise a percentage of the sale amount.
Finally, transportation costs are associated with moving products from one location to another, which often depends on the distance traveled and the quantity being moved.
For example, if a company is shipping 100 items 10 miles away, its transportation cost will be higher than if it were only sending ten things 10 miles away.
In conclusion, variable costs are essential when producing goods and services. They can quickly fluctuate based on different factors such as distance traveled, quantity created, type of material used, etc.
Why might variable expenses change significantly at different times of the year?
Variable expenses can change significantly at different times of the year due to various factors, including seasonal fluctuations, consumer demand patterns, and industry-specific considerations.
Here are some reasons why variable expenses may vary throughout the year:
Seasonal demand:
Many industries experience seasonal fluctuations in demand, resulting in varying variable expenses.
For example, the retail industry often sees increased sales during the holiday season, leading to higher variable costs such as inventory procurement, marketing campaigns, and additional staffing.
Similarly, the tourism industry may have higher variable expenses during peak vacation periods, including promotions, transportation, and accommodation expenses.
Weather conditions:
Certain businesses are highly influenced by weather conditions, leading to fluctuations in variable expenses.
For instance, a clothing retailer may experience higher variable costs during colder months as they must stock up on winter apparel.
In contrast, businesses related to outdoor activities, such as gardening or sports equipment, may see increased variable expenses during warmer seasons.
Festivals and events:
Festivals, events, and holidays can significantly impact consumer behavior and generate fluctuations in variable expenses.
Businesses catering to these events, such as restaurants, hotels, and event organizers, may experience higher variable costs during specific periods to meet increased demand.
Additional expenses may include higher inventory levels, temporary staff, and marketing efforts to attract customers during festive periods.
Production cycles:
Industries involved in manufacturing or production often have varying variable expenses due to production cycles.
For example, agricultural businesses may have higher variable costs during planting and harvesting seasons when expenses like seeds, fertilizers, and labor-intensive activities increase.
Similarly, the technology industry may experience higher variable expenses during product launches or when upgrading and testing new equipment.
Promotional campaigns:
Businesses often run promotional campaigns or events at different times of the year to boost sales.
These campaigns can lead to increased variable expenses such as advertising and marketing costs, discounts offered to customers, and additional inventory procurement to meet the anticipated demand.
These variable costs may fluctuate based on the timing and duration of the promotional activities.
Supply chain dynamics:
The availability and cost of raw materials or components can vary throughout the year, impacting variable expenses.
Industries reliant on commodities or seasonal inputs, such as agriculture or construction, may experience fluctuations in prices and availability, affecting their variable costs.
Changes in transportation costs, tariffs, or import/export regulations can also influence variable expenses associated with sourcing materials or finished goods.
Overall, variable expenses can change significantly at different times of the year due to a combination of factors related to seasonality, consumer behavior, industry-specific dynamics, and external factors.
Businesses must analyze and plan for these variations to effectively manage costs, optimize resources, and adapt to changing market conditions.
