What is Variable Cost?A variable cost is a cost that varies in relation to changes in the volume of activity. A variable cost increases as the level of activity increases; for example, the total cost of direct materials goes up in conjunction with increases in production volume. The variable cost concept can be used to model the future financial performance of a business, as well as to set minimum price points. A company with a high proportion of variable costs can usually generate a profit at a relatively low sales level, since there are few fixed costs that must also be paid for in each accounting period. Show
Types of Variable CostsThe most common variable costs are as follows:
Is Direct Labor a Variable Cost?Direct labor may not be a variable cost if labor is not added to or subtracted from the production process as production volumes change. This situation arises when a production line must be fully staffed, irrespective of the amount of production volume. This is a common situation in large and complex assembly lines, where all positions must be staffed before operations can commence. Is Overhead a Variable Cost?Overhead is not a variable cost, since overhead costs will be incurred, irrespective of production levels. For example, both rent and machine depreciation, which are overhead costs, will be incurred even if there is no production activity. The Difference Between Variable Costs and Fixed CostsA variable cost will vary with changes in activity volume, while a fixed cost will not. For example, when goods are produced, the cost of materials is considered a variable cost, since materials are only consumed when production occurs. Conversely, the depreciation cost of the equipment in the factory will be incurred, irrespective of the production volume within the facility, and so is considered a fixed cost. Costs that vary depending on the volume of activity What are Variable Costs?Variable costs are expenses that vary in proportion to the volume of goods or services that a business produces. In other words, they are costs that vary depending on the volume of activity. The costs increase as the volume of activities increases and decrease as the volume of activities decreases.  The Most Common Variable Costs
Essentially, if a cost varies depending on the volume of activity, it is a variable cost. Formula for Variable CostsTotal Variable Cost = Total Quantity of Output x Variable Cost Per Unit of OutputVariable vs Fixed Costs in Decision-MakingCosts incurred by businesses consist of fixed and variable costs. As mentioned above, variable expenses do not remain constant when production levels change. On the other hand, fixed costs are costs that remain constant regardless of production levels (such as office rent). Understanding which costs are variable and which costs are fixed are important to business decision-making. For example, Amy is quite concerned about her bakery as the revenue generated from sales are below the total costs of running the bakery. Amy asks for your opinion on whether she should close down the business or not. Additionally, she’s already committed to paying for one year of rent, electricity, and employee salaries. Therefore, even if the business were to shut down, Amy would still incur these costs until the year-end. In January, the business reported revenues of $3,000 but incurred total costs of $4,000, for a net loss of $1,000. Amy estimates that February should experience revenues similar to that of January. Amy’s list of costs for the bakery is as follows: A. January fixed costs:
Total January fixed costs: $1,700 B. January variable expenses:
Total January variable costs: $2,300 If Amy did not know which costs were variable or fixed, it would be harder to make an appropriate decision. In this case, we can see that total fixed costs are $1,700 and total variable expenses are $2,300. If Amy were to shut down the business, Amy must still pay monthly fixed costs of $1,700. If Amy were to continue operating despite losing money, she would only lose $1,000 per month ($3,000 in revenue – $4,000 in total costs). Therefore, Amy would actually lose more money ($1,700 per month) if she were to discontinue the business altogether. This example illustrates the role that costs play in decision-making. In this case, the optimal decision would be for Amy to continue in business while looking for ways to reduce the variable expenses incurred from production (e.g., see if she can secure raw materials at a lower price). Example of Variable CostsLet us consider a bakery that produces cakes. It costs $5 in raw materials and $20 in direct labor to bake one cake. In addition, there are fixed costs of $500 (the equipment used). To illustrate the concept, see the table below: Note how the costs change as more cakes are produced. Break-even AnalysisVariable costs play an integral role in break-even analysis. Break-even analysis is used to determine the amount of revenue or the required units to sell to cover total costs. The break-even formula is given as follows: Break-even Point in Units = Fixed Costs / (Sales Price per Unit – Variable Cost per Unit)Consider the following example: Amy wants you to determine the minimum units of goods that she needs to sell in order to reach break-even each month. The bakery only sells one item: cakes. The fixed costs of running the bakery are $1,700 a month and the variable costs of producing a cake are $5 in raw materials and $20 of direct labor. Additionally, Amy sells the cakes at a sales price of $30. To determine the break-even point in units: Break-even Point in Units = $1,700 / ($30 – $25) = 340 units Therefore, for Amy to break even, she would need to sell at least 340 cakes a month. Video Explanation of CostsWatch this short video to quickly understand the main concepts covered in this guide, including what variable costs are, the common types of variable costs, the formula, and break-even analysis. Related ReadingsThank you for reading CFI’s guide to Variable Costs. To keep advancing your career, the additional resources below will be useful:
What happens to variable cost per unit when activity increases?Variable costs: A variable cost increases or decreases as volume of activity increases or decreases. On a per unit basis, a variable cost per unit remains constant but the total amount of variable cost changes with the level of production.
Does variable cost change with activity level?Although variable cost per unit remain constant, total variable cost increases and decreases in proportion to changes in the activity level.
What effect does an increase in the activity level have on unit fixed costs?Fixed costs are costs that are fixed in total and do not vary in relation to the changes in activity level. As the activity level increases, the fixed cost per unit will decrease because the total amount is fixed and will be distributed in an increased activity level on a per-unit basis.
What happens when activity levels rise?What happens when activity level increases? total variable cost increases AND variable cost per unit remains constant.
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How does the variable cost per unit change as the level of activity increases?
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