What are variable costs? Definition and meaning
Variable costs, along with fixed costs, make up the total cost of production. These types of costs include the costs that can change, such as labor (UK: labour) and materials. Labor and materials costs can go up or down according to the volume of production.
When orders are high -and thus production rises – variable costs increase. However, when orders are low, they decline.
Variable cost vs. costing
The term ‘variable cost’ should not be confused with ‘variable costing.’ Variable costing is an accounting method we use 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.
Examples of variable costs include:
- Direct Materials: when production rises, we purchase more raw materials.
- 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 – employers pay their workers according to the number of units they produce – is also a cost that varies depending on production levels.
If we don’t add or subtract labor costs from the production process as activity levels change, then it might not be a variable cost. This may occur when we must have staff on the production line, regardless of production volumes.
Businesses with a high proportion of variable costs can generally generate a profit with relatively low sales levels. They can do this because their fixed costs are not high.
Variable costs – example
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 it has completed and delivered the order. Also, when 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.
A flexible budget, as opposed to a static budget, reflects the changing costs that a company experiences. We can also use the term for departments.
Put simply; flexible budgets reflect a company’s or department’s fluctuating costs.
Video – variable costs
This InvestingAnswers video explains what variable costs are in a clear and easy-to-understand way.