Variable costs

DEFINITION of variable costs

Variable costs are expenses that vary in proportion to the volume of goods or services that a business produces.

WHAT IT IS IN ESSENCE

In other words, they are costs that vary depending on the volume of activity. This increase as the volume of activities increases and they decrease as the volume of activities decreases.

Essentially, if a cost varies depending on the volume of activity, it is a variable cost.

The most common forms of variable cost include direct materials, direct labor, transaction fees, commissions, utility costs, billable labor. These expenses will rise if production increases, as the business will need more raw materials and more workers. If production drops, these costs can drop also.

The ratio of variable costs to fixed costs is an important factor for businesses and their investors.

It indicates how much profit can be made from an increase in sales, and how much a drop in sales could hurt a business’s bottom line.

A business with higher variable costs relative to fixed costs is likely to have more consistent profitability. That’s because the break-even point is lower, due to lower fixed costs, and higher variable costs yield lower profits per unit sold.

HOW TO USE

Variable costs vary because they can increase and decrease as you make more or less of your product. The more units you sell, the more money you’ll make, but some of this money will need to pay for the production of more units. So, you’ll need to produce more units to actually turn a profit.

And because each unit requires a certain amount of resources, a higher number of units will raise the variable costs needed to produce them.

As production volume increases, it is often possible to negotiate or renegotiate, purchasing agreements to further reduce your per-unit cost. That is especially true with raw materials and shipping. The higher the production volume, the greater you are negotiating power.