Definition:

A variable cost is a direct cost that the total costs or expenses are changing when the to the 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 and if production is slowed down, variable costs decrease. Some examples of variable costs include the cost of raw materials and packaging.

Formula:

To calculate 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 calculate as the follow,

Variable cost per unit = Total Variable Costs / Total Quantity of Output

Variable Cost and its comparison to Fixed cost

Variable costs and fixed costs are two of the main costs incurred by a company when producing goods and services.

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 that a company can avoid fixed costs.

These are expenses that have to be paid by a company, independent of any specific business activity. Some examples of fixed costs are depreciation, rent, insurance, and indirect labor.

 Fixed costsVariable costs
DefinitionCost that don’t change in relation to the production volumeCosts that vary or change in relation to production volume
NatureFixed costs are the time-related, as they remain the same for the period of timeVariable costs are volume-related, as they change with the changes in production volume
When production increases or decreaseThe total fixed cost stays the sameTotal variable cost increase/decrease
ExampleRental expense, advertising expenses, depreciation expenses, insurance expenses, etc.Direct material (sugar, egg, wood, cement), direct labor ( salary or wags)

Examples of Variable Costs:

  1. Direct materials: These are the raw materials that go into the making of a product. As the number of produced goods increases, the number of raw materials required increases as well.
  2. Piece rate of labor: This is the amount paid to workers for each unit completed. The higher the production, the higher the labor wages and vice versa in case of lower production.
  3. Production supplies: These costs vary with the production volume, for example, machinery oil is consumed based on the amount of machinery used by the company for the production of goods and services.
  4. Commissions: Salespeople are paid commission in excess of their salaries only if they sell a product or service.
  5. Freight cost: A shipping cost is incurred by the company when it sells and ships out a product.
  6. Billable staff wages: If a company pays its workers on the basis of the number of hours worked, then it is a variable cost. However, if they are paid monthly salaries, then it will be a fixed cost.
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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, flour and 10 dollars for the direct labour 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 to decrease.

When the bakery makes zero cakes, the variable costs are also zero since no sugar, milk, or flour is required.

Sometimes, a company can increase its profits by decreasing their total costs, but 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.

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 absorption costing income statement.

If a company uses a variable costing income statement, then defining variable costs is very easy.

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 statement and under the sales revenue.

A line-item on the income statement, cost of goods sold, includes direct labour and direct material cost which is summed up with another line-item I.e. variable selling expenses.

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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.