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.
Variable costs are expenses that change based on production levels — rising as production levels rise, and falling when production levels drop. Variable costs play an important role in business operations, affecting everything from your break-even analysis, which tells you how many units you need to sell in order to break even, to your net profit.
In order to optimally manage variable costs, you first have to understand what they are, how they differ from fixed costs, and what the most common variable costs are.
Variable costs vs. fixed costs: What's the difference?
There is a significant difference between fixed costs and variable costs. Variable costs always vary with production levels, while fixed costs remain the same. For example, direct material costs are always a variable cost, because they will increase or decrease in relation to production levels.
On the other hand, fixed costs, such as rent and insurance, will remain the same from month to month, regardless of production levels.
Examples of variable costs
One of the easiest ways to determine whether a cost is variable or fixed is whether it changes from month to month, or remains the same every month. There are many variable costs that a business incurs monthly, but these are the most common ones.
1. Raw materials
Raw materials are perhaps the largest variable cost your business will have. Raw materials are what's used to create your finished product, and their cost will always vary depending on production levels.
2. Direct labor
Direct labor, such as hourly wages, can vary depending on production levels. For example, managers may have their employees work an extra shift and will then need to pay overtime.
Additional employees may also be added to the production line when production levels are up, or subsequently furloughed when production levels drop. While not all wages are affected by production, the wages of direct employees are.
3. Manufacturing supplies
Manufacturing supplies are items directly related to the manufacturing process. Gloves for machine workers or equipment cleaning supplies are examples of manufacturing supplies. Because these costs can vary based on production levels, manufacturing supplies are always considered a variable cost.
While commissions are not included in the cost of goods sold, they are a variable cost that increases or decreases based on production levels. The higher your production levels, the more commissions you should be paying, or your sales staff is not doing its job.
Freight is another expense not included in the cost of goods sold, but it increases or decreases based on production.
If you sell directly, you'll be incurring the cost of shipping to your customers, while if you’re shipping in bulk to a store or distributor, you'll be paying freight costs. Either way, the shipping costs rise along with production levels.
How to calculate variable costs
It’s impossible to determine accurate pricing for your products without properly calculating variable costs. In order to ensure that your profit margin is adequate and you have the funds available to cover your operating costs, you need to calculate variable costs.
1. Production cost
If you only sell one product, it’s easy to calculate your variable costs. For example, you produce 500 pairs of men’s athletic shoes in the month of June. Your variable costs are as follows:
- Materials to produce the shoes: $10,000
- Direct labor to manufacture the shoes: $13,000
- Additional materials: $$2,000
- Packaging costs: $500
The total variable cost to produce 500 pairs of shoes is $25,500. To calculate the cost of producing one unit, or one pair of shoes, you would divide the total cost by the number of shoes produced:
$25,500 ÷ 500 = $51
That means the total direct cost to produce one pair of shoes is $51. Knowing these costs can help you make more informed decisions in the future. For example, if you decide to double production in July, you can accurately forecast your variable costs to be around $51,000.
2. Total variable cost
In Step 1, we calculated total production costs, but it’s helpful to know your total variable cost as well. To do so, you’ll need to add other variable costs not directly related to the production process.
For instance, in the month of June, the freight to ship the shoes totaled $5,100, the commissions you paid to the sales staff totaled $4,750, and the cost of the electricity to power the machines was $1,200.
Added together, these costs totaled $11,050. To calculate the total variable cost for producing 500 pairs of shoes, do the following calculation:
$25,500 (direct cost of production) + $11,050 (other variable costs) = $36,550
The variable cost formula used to calculate the cost of producing one pair of shoes would be:
$36,550 ÷ 500 = $73.10
This total includes all of the direct costs to manufacture the shoes, the cost of selling the shoes, and the cost of shipping the shoes to the customer or distributor.
This total does not include additional operating expenses that will need to be factored in as well. Knowing your variable costs can help you address certain issues such as a low profit margin, high production costs, and inaccurately priced products.
How to reduce variable costs in your business
Assuming you sell a pair of shoes for $95 each, you’ll want to subtract the total variable cost:
$95 - $73.10 = $21.90
Using the calculation above, we’ve determined that you’re making $21.90 on each pair of shoes sold. This total does not include indirect costs such as building rent or administrative overhead, meaning you’re actually making less than $21.90 for each pair of shoes you sell once those costs are factored in.
If you want to increase your profit margin, you’ll likely have to reduce variable costs, as fixed costs such as rent and insurance cannot easily be reduced. Fortunately, there are a number of things you can do to cut variable costs:
- Reduce direct materials cost: If your current direct materials cost is high, start shopping around for another supplier with lower costs. You may also be able to negotiate a lower price with your current supplier if you buy in bulk.
- Raise prices: If your shoes sell very well, chances are you might be able to raise prices without it affecting sales levels.
- Reduce labor costs: Your employees spend a lot of time on the line manufacturing the shoes. Are there ways they can become more efficient? If your machines are old, you may also want to consider purchasing more efficient machines.
- Reduce shipping costs: Perhaps right now, you allow your customers to choose from three different shippers. By contracting with a single shipper, it may be possible to reduce your shipping costs.
- Reduce commissions: While cutting commissions is an option, it’s always best to look at cutting other costs before cutting employee incentives such as commissions, which may end up costing you sales.
Variable costs are an important part of doing business
Accurately calculating your variable costs can help you complete a number of essential business tasks, including:
- Pricing products correctly
- Creating accurate business budgets
- Calculating your break-even point
- Creating accurate financial projections
Tracking variable costs properly will help you estimate production costs more accurately, price your products better, and ensure that your general ledger accounts are properly maintained — all of which are important tasks for every small business owner.