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Definition Of Variable Cost

variable cost definition and example

Typical household fixed expenses are mortgage or rent payments, car payments, real estate taxes and insurance premiums. While you could theoretically change your monthly mortgage payment by refinancing your loan or by appealing your property tax assessment, this is not an easy switch. And, because each unit requires a certain amount of resources, a higher number of units will raise the variable costs needed to produce them. By reducing variable costs by $7, the company now earns 14% higher gross profits off of every sale. Generally, when a business is looking for ways to reduce costs, they will focus on variable costs because these are more easily changed in the short term. Total cost is found by adding variable and fixed costs together. Variable Costs are the expenses that change proportionally with the volume of goods or services which a company produces.

variable cost definition and example

There is also a category of costs that falls between fixed and variable costs, known as semi-variable costs (also known as semi-fixed costs or mixed costs). These are costs composed of a mixture of both fixed and variable components. Costs are fixed for a set level of production or consumption and become variable after this production level is exceeded. If no production occurs, a fixed cost is often still incurred.

For Supermarkets and other retailers, it must have its electricity on for 12 hours or so a day. On the other hand, the cost to run a production line has a direct relationship between cost and output. So for manufacturing and other such firms, utilities count https://online-accounting.net/ as a variable cost. By contrast, the variable cost is the commission paid to the salesperson based on the number of sales they make. So when the salesperson makes 2 sales, they get paid for those, whilst if they make 10 sales, they earn even more.

A variable cost that is paid becomes a form of fixed cost called a sunk cost. Avoidable fixed costs become unavoidable fixed costs once the cost has been paid.

Variable Costs

If your business has a mortgage loan, it amortizes it over time until the loan is paid off and the principal and interest are down to zero dollars. Amortization – the allocation of the cost of an intangible asset over a period of time. However, it is important to ensure that any cuts made to these expenses do not negatively affect the quality of the service or product being offered. Often these can be cut quickly and more effectively than fixed expenses.

A variable cost is an expense that rises or falls in direct proportion to production volume. Variable costs differ from fixed costs, which remain the same even as production and sales volume changes. As we can see from the graph below, the variable cost is in stark contrast to fixed costs. Whilst a fixed cost remains constant, variable costs change in line with output. Whilst the graph depicts a straight line, this may vary in real life.

In a survey of nearly 200 senior marketing managers, 60 percent responded that they found the “variable and fixed costs” metric very useful. On the other hand, variable costs show a linear relationship between the volume produced and total variable costs. While it usually makes little sense to compare variable costs across industries, they can be very meaningful when comparing companies operating in the same industry. They denote the amount of money spent on the production of a product or service and are among the most important analyses a business can run.

Variable Costdefinition, Examples & Calculation

By cutting production volume, variable costs can be reduced, whereas fixed costs will still be charged regardless of production activity. Some common examples of variable costs are the direct materials and labor used in production, utility expenses, and freight. In order to understand how variable costs impact your profit margins, it’s useful to know how fixed costs work. Unlike variable costs, this type of expense stays the same regardless of how much you produce or sell of your products.

  • This means that if the sales drop, the EBIT will drop at a higher rate for a company having a higher proportion of fixed cost compared to a company with a low level of fixed cost.
  • The main variable cost will be materials and any energy costs actually used in production.
  • But, however, as the sales increase the profit margin generated will be less than that would have been generated with the higher fixed cost.
  • But what are variable costs and how do they compare to fixed expenses?
  • This can be illustrated by graphing the short run total cost curve and the short run variable cost curve.
  • If the company has no sales, the total sales commission expense will be $0.

Commercial leases often have a fixed rent per month plus an additional rent based on the amount of production or sales. For example, rent is $5,000 plus five cents for each pencil that is made.

The Accounts Receivable Collection Period: Definition, Formula, Example, And Explanation

Companies with high variable costs need to produce less to break even but they also have lower profit margins than companies with high fixed costs, according to Business Dictionary. Some common examples of variable costs include raw materials, direct labor, packaging, freight, and utilities.

IG International Limited receives services from other members of the IG Group including IG Markets Limited. This would mean that the company might need to cut jobs or buy in less of the materials that they use to make their products. The major lesson here is that in spite of their name, “fixed” expenses are not necessarily set in stone. If you lose your job or aggressively want to start saving, you could devote a few hours to culling your fixed expenses.

Definition Of Variable Cost

A business needs to sell at least a certain number of units or goods to cover all costs to variable cost definition and example be profitable. This number of units or goods is called the break-even point or quantity.

variable cost definition and example

But, for the most part, businesses fall into one of these two camps. Variable expenses represent those daily spending decisions like eating at restaurants, buying clothes, drinking Starbucks, and playing a round of golf with your buddies. These can include parts, cloth, and even food ingredients required to make your final product. Rent – the rent you pay on your office, factory, and storage space. Insurance – the liability insurance you hold on your business. Depreciation – the gradual deduction of an asset’s decline in value.

What Are Some Examples Of Variable Costs?

Variable costs are directly related to the cost of production of goods or services, while fixed costs do not vary with the level of production. Variable costs are commonly designated as COGS, whereas fixed costs are not usually included in COGS.

  • To accurately forecast corporate expenses, you need to learn how to calculate variable costs.
  • Variable cost is one of the two major cost categories that you’ll find in nearly every business endeavor.
  • Over a five-year horizon, all costs can become variable costs.
  • It’s much easier to budget for fixed expenses than it is to budget for a variable expense or discretionary expense.
  • They play a role in several bookkeeping tasks, and both your total variable cost and average variable cost are calculated separately.
  • A fixed cost is a cost that does not change with an increase or decrease in the amount of goods or services produced or sold.
  • While fixed costs do change over a long-term period, this change isn’t related to production.

Learn more about the standards we follow in producing Accurate, Unbiased and Researched Content in our editorial policy. In a situation such as this, a company would need to find the reason it is unable to attain economies of scale. Our toy manufacturer lost money on sales of 10 and 20 music boxes and only broke even when it reached 56 sales.

Sales Commissions

This effect can be related to materials, labor, and sales commissions. For example, if you produce spark plugs, the copper used in production is a variable cost. This means if you stop producing spark plugs, you would no longer have the cost of copper. Additionally, regardless of how many spark plugs you produce, the price of copper for one spark plug remains unchanged. If companies ramp up production to meet demand, their variable costs will increase as well. If these costs increase at a rate that exceeds the profits generated from new units produced, it may not make sense to expand.

If no production or services are provided, then there should be no variable costs. If production or services are increasing, then variable costs should also increase. It is useful to understand the proportion of variable costs in a business, since a high proportion means that a business can continue to function at a relatively low sales level. Conversely, a high proportion of fixed costs requires that a business maintain a high sales level in order to stay in business. In general, companies with a high proportion of variable costs relative to fixed costs are considered to be less volatile, as their profits are more dependent on the success of their sales.

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