What is Variable Cost?
Variable cost is an expense that changes in relation to a company’s business activity. As opposed to fixed costs, which remain constant, these costs arise in direct proportion to a business’s output, increasing and decreasing along with the volume of production. Most often, variable rates are associated with production and packaging materials, as well as some hourly wage labor expenses.
Cost often changes according to consumer demand, rather than according to managerial oversight. For example, manufacturing activity typically increases and decreases when there is more or less demand for a product, respectively. The ebb and flow of expenses paid out for raw production materials in response to these shifting demands add up to the variable cost of a company. Relatedly, when production levels dip, less energy is required to run a company; thus some electric bills can also be considered a variable expense.
Variable expense is occasionally also known as unit-level cost, since it changes with the number of units of production. Additionally, it is also defined as the sum of marginal costs over time, or even simply “normal costs.” Variable expenses can be either direct costs (expenses paid for services that directly pertain to a specific project) or indirect costs (services that can be used for multiple projects). For instance, these costs might include a salary or wage for a particular assignment (direct cost) or overhead manufacturing costs (indirect).
Variance in cost is a natural part of company operation, so an increase in expenses should not necessarily be cause for alarm. In fact, at times this increase can signal business success, as it often indicates heightened demand for goods or services, and thus greater revenue. Still, it is important for any business to maintain a balance in its variable expenses, so that the cost of raw materials does not exceed revenue. Understanding your variable cost can help you track your profits.
Variable cost percentage is an important indicator for investors seeking to buy into a particular company. The ratio of variable expenses to overall revenue can provide insight which companies will be able to manage their own expense budgets and turn costs into profit. Banks and other investors often conduct studies into companies’ cost trends using margin analysis, whereby revenue is divided by variable expenses to determine sales percentages and break-even points.
Despite the fact that variable rates are often juxtaposed with fixed costs, the fact of the matter is that at some point, all costs in a company will be variable. In a competitive market, prices of products and raw materials will fluctuate, and a business’s costs will also change accordingly. Even salaries, often considered a fixed cost, will change over time with raises or layoffs, rendering that expense variable as well. Generally, changes in factors like tax rates are not considered in the calculation of variability.
Variable costing is the accounting formula by which variable expenses are determined. The variable cost is important to potential investors. This method generally proves that on the whole, a business with few variant expenses and many fixed costs will be able to maximize profits most predictably, as its revenue is not affected by widely erratic variables. On the other hand, a company with frequent variable expense will more likely demonstrate a higher number of short-term unpredictable profits.