Variable costs, along with fixed costs make up the total cost of production. Variable costs include the costs that can change, such as labor (UK: labour) and material, which can go up or down according to the volume of production. When orders are high -and thus production rises – variable costs increase, when orders are low, variable costs decline.
The term ‘variable cost’ should not be confused with ‘variable costing’ – an accounting method used when reporting variable costs.
Fixed costs rarely change on a month-to-month or quarter-to-quarter bases, while variable costs do. Examples of fixed costs include rent, insurance premiums, machine depreciation, and office supplies.
Variable costs are costs that rise or fall in proportion to the good or service that a business produces.
Examples of variable costs include:
– Direct Materials: when production rises, more materials used to make products are purchased.
– Commissions: sales representative do not sell the same amount each month. If they receive performance-related commissions, this cost will change from month-to-month.
– Labor Costs: billable labor costs are charged to expense when the associated sales transactions are completed, says accountingtools.com. Piece-rate labor – employees who are paid according to the number of units produced – is also a cost that varies depending on production levels.
If labor costs are not added or subtracted from the production process as activity levels change, then it might not be a variable cost. This may occur when a production line has to be staffed, regardless of production volumes.
Businesses with a high proportion of variable costs can generally generate a profit with relatively low sales levels, because their fixed costs are not high.
(Left) Variable costs include labor and materials, while fixed costs (Right) include insurance premiums, office rent and utilities.
An example of variable costs
Imagine John Doe Inc. has received an order for 5,000 door-handles for a total sales price of $10,000. It wants to find out what the gross profit will be when the order is completed and delivered, and the client has paid.
First, the company must determine the variable costs per door-handle.
Let’s assume that:
– It produces 100,000 door handles per year
– Material costs total $10,000
– Direct labor costs are $50,000
Therefore, each door handle costs $10,000 (material) ÷ 100,000 (units) = $0.10 or ten cents in raw materials, and $50,000 (labor) ÷ 100,000 (units) = $0.50 or fifty cents in direct labor costs. By using this formula, it is possible to work out what John Doe’s total variable cost for this order is:
5,000 units x ($0.10 material cost per unit + $0.50 labor cost per unit) = $3,000
Therefore, the gross profit from this order should be $5000 minus $3,000 = $2,000.
Video – Definition of variable costs
This InvestingAnswers video explains what variable costs are in a clear and easy-to-understand way.