# Variable Cost: What It Is and How to Calculate It

> **Definition**
>
> A variable cost is a business expense that’s directly affected by production.

## What Is a Variable Cost?

Business expenses broadly fall into two categories: variable or fixed. Fixed costs remain constant regardless of changes in the level of production. Variable costs fluctuate with the level of production. The cost of raw materials would be variable because it rises or falls when a company increases or decreases production.

### Key Takeaways

*   Variable costs are the opposite of fixed costs, which remain constant when production is increased or decreased.
*   Variable costs are a key factor in determining a product's contribution margin, the metric used to determine a company's break-even number or its target profit number.
*   Examples of variable costs include raw materials, hourly labor, utilities, commissions, and distribution costs.

![Variable Cost: A corporate expense that changes in proportion to how much a company produces or sellsârising as production increases and falling as production decreases.](https://www.investopedia.com/thmb/rYXRPq67yiQh970DI3YwCj3afAY=/1080x0/filters:no_upscale():max_bytes(150000):strip_icc()/variablecost_definition_0718_FINAL-e0747f53ef45413c91e7d656a7a9b766.png)

*Raw materials, piece-rate labor, supplies, commissions, and delivery costs are examples of variale costs. — Investopedia / Sydney Saporito*

## How Variable Costs Work

The total expenses incurred by any business consist of variable and fixed costs.

Variable costs are dependent on the level of production output or sales. The variable cost of production is a constant amount per unit produced. As the volume of production and output increases, variable costs will also increase.

Examples of variable costs are sales [commissions](https://www.investopedia.com/terms/c/commission.asp), direct labor costs, cost of raw materials used in production, and utility costs.

> **Important**
>
> Variable costs are usually viewed as short-term costs as they can be adjusted quickly. For example, if a company is having cash flow issues, it may immediately decide to alter production to reduce costs.

## Formula and Calculation of Variable Costs

The total variable cost is the quantity of output multiplied by the variable cost per unit of output:

**Total Variable Cost  =  Total Quantity of Output x Variable Cost Per Unit of Output**

The variable cost per unit will vary across profits. In general, it can often be specifically calculated as the sum of the types of variable costs. Variable costs may need to be allocated across goods if they are incurred in batches (i.e. 100 pounds of raw materials are purchased to manufacture 10,000 finished goods).

## Types of Variable Costs

Along the manufacturing process, there are specific expenses that are usually variable costs. For the examples of these variable costs below, consider the manufacturing and distribution processes for an athletic apparel producer.

### Raw Materials

[Raw materials](https://www.investopedia.com/terms/r/rawmaterials.asp) are the goods that a business purchases to create a final product. If the athletic brand buys the shoes rather than manufacturing them, it won't incur the cost of leather, mesh, canvas, or other raw materials.

In general, a company should spend roughly the same amount on raw materials for every unit produced assuming no major differences in manufacturing one unit versus another.

### Direct Labor

Direct labor costs will vary depending on the units produced. The more units produced, the more direct labor costs.

Some labor costs will be incurred even if no units are produced. A salaried accountant or company lawyer will be paid whether the company's output is 100,000 units or 0 units.

For others who are paid an hourly rate, more labor hours result in higher paychecks.

### Commissions

[Commissions](https://www.investopedia.com/terms/c/commission.asp) are a percentage of a sale's proceeds that are awarded to a salesperson as additional compensation. If no sales are executed, there is no commission expense.

Because commissions rise and fall in line with whatever underlying target the salesperson must hit, the expense varies with changes in production.

### Utilities

When a manufacturer line ramps up production, it consumes more energy. When production is shut down, minimal utilities are consumed.

In this example, utilities usually vary with production. As a company strives to produce more output, it is likely to require additional power, resulting in increased variable utility costs.

### Shipping/Freight

The total cost of shipping finished products varies depending on the number of units shipped.

There may be fixed cost components, such as the cost of an in-house email [distribution network](https://www.investopedia.com/terms/d/distribution-network.asp), but most shipping costs are variable.

## Importance of Variable Cost Analysis

Variable costing data is used to analyze expenses, pricing, and profitability. Variable cost analysis is important for the following reasons:

*   **Variable costs help determine pricing.** A company strives to [competitively price](https://www.investopedia.com/terms/c/competitive-pricing.asp) its goods to recover the cost of manufacturing them. By performing variable cost analysis, the company can establish the right price for its products to turn a profit.
*   **Variable costs are an integral part of budgeting and planning.** A company may plan to double its output next year to scale revenue. To do so, it must calculate the impact on its expenses. Any strategic plans relating to growth, contraction, or expansion to new products incur changes to variable costs
*   **Variable costs determine the break-even point.** A company's [break-even point](https://www.investopedia.com/terms/b/breakevenpoint.asp) is calculated as fixed costs divided by contribution margin, and contribution margin is calculated as revenue minus variable costs. A company can leverage variable cost analysis to calculate exactly how many items it needs to sell to break even and how many units it needs to sell to make a [specific amount of money](https://www.investopedia.com/terms/p/profit-volume-chart.asp).
*   **Variable costs determine margins and net income.** Gross margin, profit margin, and net income calculations are calculated with a combination of fixed and variable costs. By performing variable cost analysis, a company can easily identify how scaling or decreasing output will impact profit calculations.
*   **Variable costs impact a company's expense structure.** Imagine a company that wants to rent a piece of equipment. It can choose between paying $1,000 (fixed cost) or $0.05 for every item manufactured. This decision will have a direct impact on the profitability and earning potential of the company since its expense structure determines its leverage.

## Variable Cost vs. Average Variable Cost

Variable cost and average variable cost are not the same. While variable cost measures the cost of producing a single product, average variable cost analyzes production over time and compares variable costs to what has been produced. The average variable can be calculated as:

**Average Variable Cost = Total Variable Costs / Total Output**

Variable cost and average variable cost may not always be equal due to price increases or discounts. Consider the variable cost of a project that has been worked on for years. The salary of an employee assigned to the project is a variable cost and, in this case, the employee was promoted last year. The current variable cost will be higher than before; the average variable cost will remain somewhere in between.

Average variable cost is often U-shaped when plotted graphically. Therefore, a company can use average variable costing to analyze the most efficient point of manufacturing by calculating when to shut down production in the short term or even when to shut down a plant.

## Variable Costs vs. Fixed Costs

Fixed costs remain the same regardless of production output. Examples of fixed costs are rent, salaries, [insurance](https://www.investopedia.com/terms/i/insurance.asp), and office supplies.

A company must pay these expenses irrespective of the volume of products it manufactures and sells. Whether production increases or decreases, rent will stay the same.

Even fixed costs can change over time, but the change will not be related to production. As such, fixed costs are viewed as long-term expenses.

There is also a category of costs that falls between fixed and variable costs, known as [semi-variable costs](https://www.investopedia.com/terms/s/semivariablecost.asp) (sometimes called semi-fixed costs or mixed costs). These are costs composed of a [mixture of fixed and variable components](https://www.investopedia.com/terms/s/scattergraph-method.asp). 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.

> **Fast Fact**
>
> 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.

## Special Considerations

Several factors play into an evaluation of a company's expenses, fixed or variable. These include relevant range, degree of leverage, and contribution margin.

### Relevant Range

The concept of relevant range primarily relates to fixed costs. This may hold true for tangible products associated with the production of goods as well as labor costs, particularly overtime costs.

Consider [wholesale](https://www.investopedia.com/terms/w/wholesaling.asp) bulk pricing that prices goods in tiers based on the quantity ordered. Raw materials may cost $0.50 per pound for the first 1,000 pounds, while orders of greater than 1,000 pounds are charged $0.48. In either situation, the variable cost is the charge for the raw materials (either $0.50 per pound or $0.48 per pound).

> **Fast Fact**
>
> You can find a company's variable costs on their balance sheet under cost of goods sold (COGS). This measures the costs that are directly tied to production, such as the costs of raw materials and labor. While COGS can also include fixed costs, such as overhead, it is generally considered a variable cost.

### Degree of Leverage

Variable and fixed costs play into the degree of [operating leverage](https://www.investopedia.com/terms/o/operatingleverage.asp) a company has.

In short, fixed costs are riskier, they generate a greater degree of leverage, and they leave the company with greater upside potential. Variable costs are safer, generate less leverage, and leave the company with a smaller upside potential.

Consider the example above with a company choosing between renting a piece of equipment for $1,000 or $0.05 per unit produced:

*   If the company manufactures just one unit of output, it is $999.95 more favorable to opt for the per-unit price.
*   If the company manufactures 20,000 units of output, the two options break even.
*   If the company manufactures 1,000,000 units of output, it is $49,000 more favorable to opt for the fixed price.

The company faces the risk of loss if it produces less than 20,000 units. However, anything above this has limitless potential for yielding benefits for the company.

Therefore, leverage rewards the company for not choosing variable costs, as long as the company can produce enough output.

### Contribution Margin

Variable costs are a direct input in the calculation of [contribution margin](https://www.investopedia.com/terms/c/contributionmargin.asp), the amount of proceeds a company collects after using sale proceeds to cover variable costs.

Every dollar of contribution margin goes directly to paying for fixed costs; once all fixed costs have been paid for, every dollar of contribution margin contributes to profit.

For this reason, variable costs are a required item for companies trying to determine their break-even point. In addition, variable costs are necessary to determine sale targets for a specific profit target.

## Example of a Variable Cost

Let’s assume that it costs a bakery $15 to make a cake—$5 for raw materials such as sugar, milk, and flour, and $10 for the direct labor involved in making one cake. The table below shows how the variable costs change as the number of cakes baked varies.

As the production output of cakes increases, the bakery’s variable costs also increase. When the bakery does not bake any cake, its variable costs drop to zero.

Fixed costs and variable costs comprise the total cost. Total cost is a determinant of a company’s profits, which is calculated as:

> $\begin{aligned} &\text{Profits} = Sales - Total~Costs\\ \end{aligned}$

A company can increase its profits by decreasing its total costs. Since fixed costs are more challenging to bring down (for example, reducing rent may entail moving to a cheaper location), most businesses seek to reduce their variable costs. Decreasing costs usually means decreasing variable costs.

If the bakery sells each cake for $35, its [gross profit](https://www.investopedia.com/terms/g/grossprofit.asp) per cake will be $35 - $15 = $20. To calculate the net profit, the fixed costs have to be subtracted from the gross profit. Assuming the bakery incurs monthly fixed costs of $900, which includes utilities, rent, and insurance, its monthly profit will look like this:

A business incurs a loss when fixed costs are higher than gross profits. In the bakery’s case, it has gross profits of $700 - $300 = $400 when it sells only 20 cakes a month. Since its fixed cost of $900 is higher than $400, it would lose $500 in sales.

The break-even point occurs when fixed costs equal the [gross margin](https://www.investopedia.com/terms/g/grossmargin.asp), resulting in no profits or losses. In this case, when the bakery sells 45 cakes for a total variable cost of $675, it breaks even.

A company that seeks to increase its profit by decreasing variable costs may need to cut down on fluctuating costs for raw materials, direct labor, and advertising. However, the cost cut should not affect product or service quality as this would damage sales.

By reducing its variable costs, a business increases its gross profit margin or [contribution margin](https://www.investopedia.com/terms/c/contributionmargin.asp).

The contribution margin allows management to determine how much revenue and profit can be earned from each unit of product sold. The contribution margin is calculated as:

$\begin{aligned} &\text{Contribution~Margin} = \dfrac{Gross~Profit}{Sales}=\dfrac{ (Sales-VC)}{Sales}\\&\textbf{where:}\\&VC = \text{Variable Costs}\\ \end{aligned}$

The contribution margin for the bakery is ($35 - $15) / $35 = 0.5714, or 57.14%. If the bakery reduces its variable costs to $10, its contribution margin will increase to ($35 - $10) / $35 = 71.43%. Profits increase when the contribution margin increases. If the bakery reduces its variable cost by $5, it would earn $0.71 for every dollar in sales.

## What Are Some Examples of Variable Costs?

Common examples of variable costs include [costs of goods sold](https://www.investopedia.com/terms/c/cogs.asp) (COGS), raw materials and inputs to production, packaging, wages, commissions, and certain utilities (for example, electricity or gas [costs that increase with production capacity](https://www.investopedia.com/terms/c/capacity-cost.asp)).

## How Do Fixed Costs Differ From 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.

Fluctuations in sales and production levels can affect variable costs if factors such as sales commissions are included in per-unit production costs. Fixed costs must still be paid even if production slows down significantly.

## How Can Variable Costs Impact Growth and Profitability?

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 doesn't make sense to expand.

A company in such a case will need to evaluate why it cannot achieve economies of scale. In economies of scale, variable costs as a percentage of overall cost per unit decrease as the scale of production ramps up.

## Is Marginal Cost the Same As Variable Cost?

No. Marginal cost refers to how much it costs to produce one additional unit. The marginal cost will take into account the total cost of production, including both fixed and variable costs. Since fixed costs are static, the weight of fixed costs will decline as production scales up.

## What Is the Formula for Total Variable Cost?

Because variable costs scale alongside, every unit of output will theoretically have the same amount of variable costs. Therefore, total variable costs can be calculated by multiplying the total quantity of output by the unit variable cost.

## The Bottom Line

In a manufacturing process, there are different types of costs. One type of cost is variable, increasing only if the quantity of output also increases. While a fixed cost remains the same over a relevant range, a variable cost usually changes with every incremental unit produced.

Though this cost structure protects a company in the event the demand for their goods decreases, it limits the upside profit potential the company could have received with a more fixed-cost-focused strategy.

> **Article Sources**
>
> 1.  Business Development Bank of Canada. "[Cost of Goods Sold](https://www.bdc.ca/en/articles-tools/entrepreneur-toolkit/templates-business-guides/glossary/cost-of-goods-sold)."