Variable costs

What Is Variable Costs?

Variable costs are expenses that directly change in proportion to the volume of goods or services a business produces. As production increases, so do total variable costs, and conversely, as production decreases, total variable costs fall. These costs are a crucial component of managerial accounting, helping businesses understand the true cost of each unit produced and inform strategic decisions regarding pricing, output levels, and profitability. Unlike fixed costs, which remain constant regardless of production volume, variable costs are directly tied to operational activity.

History and Origin

The concepts underlying variable costs, and cost accounting in general, trace their origins back to the Industrial Revolution in the late 18th and early 19th centuries. As manufacturing processes grew in complexity and scale, businesses increasingly needed detailed financial information to manage operations efficiently. Early methods focused on understanding the direct costs associated with producing goods, such as raw materials and labor. The distinction between costs that varied with production and those that remained constant became increasingly important for internal decision-making. The Federal Reserve Bank of San Francisco notes that cost accounting emerged as industries like textiles and railroads expanded, necessitating more sophisticated tools to track and manage expenses.⁶

Key Takeaways

• Direct Relationship: Variable costs fluctuate directly with changes in the volume of goods or services produced.
• Per-Unit Consistency: While total variable costs change, the variable cost per unit typically remains constant over a relevant range of production.
• Decision-Making Tool: Understanding variable costs is vital for pricing products, analyzing profitability, and making short-term operational decisions.
• Internal Focus: Variable costing is primarily used for internal management reporting and analysis, not typically for external financial statements under Generally Accepted Accounting Principles (GAAP).
• Impact on Break-Even: Variable costs play a critical role in calculating a company's break-even point.

Formula and Calculation

The calculation of variable costs can be expressed in two primary ways: total variable costs and variable cost per unit.

1. Total Variable Costs (TVC):
   This is the sum of all variable costs incurred for a given period or production level.

   $$TVC = VCPU \times Q$$

   Where:

   • (TVC) = Total Variable Costs
   • (VCPU) = Variable Cost Per Unit
   • (Q) = Quantity of units produced

2. Variable Cost Per Unit (VCPU):
   This measures the variable cost attributed to each individual unit of output.

   $$VCPU = \frac{TVC}{Q}$$

   Where:

   • (VCPU) = Variable Cost Per Unit
   • (TVC) = Total Variable Costs
   • (Q) = Quantity of units produced

These calculations are fundamental for understanding the cost of goods sold and assessing the financial viability of increasing or decreasing production.

Interpreting the Variable Costs

Interpreting variable costs involves understanding their impact on a company's financial performance and operational flexibility. A high proportion of variable costs relative to total costs can offer greater flexibility, as expenses scale down more easily when sales decline. Conversely, a business with lower variable costs and higher fixed costs may face more significant challenges during downturns due to its inability to reduce expenses quickly. Analyzing variable costs helps management assess the marginal cost of producing an additional unit, which is crucial for pricing strategies and production decisions. The contribution margin, derived by subtracting variable costs from revenue, indicates how much sales revenue is available to cover fixed costs and generate profit.

Hypothetical Example

Consider "GadgetCo," a company that manufactures small electronic devices.
Let's analyze their variable costs for producing widgets.

Scenario:

• Direct Materials: Each widget requires $5 in raw materials (e.g., circuit boards, casings).
• Direct Labor: It takes 0.5 hours of labor to assemble one widget, and the labor rate is $20 per hour. So, $10 per widget for direct labor.
• Variable Manufacturing Overhead: This includes costs like electricity for machinery and production supplies, estimated at $2 per widget.

Calculation:

1. Variable Cost Per Unit (VCPU):

   • Direct Materials: $5
   • Direct Labor: $10 ($20/hour * 0.5 hours)
   • Variable Manufacturing Overhead: $2
   • Total VCPU = $5 + $10 + $2 = $17 per widget.

2. Total Variable Costs at Different Production Levels:

   • If GadgetCo produces 1,000 widgets:
     • Total Variable Costs = $17/widget * 1,000 widgets = $17,000.
   • If GadgetCo produces 2,000 widgets:
     • Total Variable Costs = $17/widget * 2,000 widgets = $34,000.

This example clearly illustrates how total variable costs increase directly with the production volume, while the variable cost per unit remains constant.

Practical Applications

Variable costs are integral to various aspects of business operations and financial analysis. In budgeting and planning, they allow companies to forecast expenses based on projected sales or production volumes, enabling more accurate budgeting. For pricing decisions, understanding variable costs is crucial for setting prices that not only cover the per-unit cost but also contribute to covering overhead and generating profit.

Companies also use variable costs in profitability analysis, particularly when evaluating the viability of special orders or product lines using contribution margin analysis. For example, a firm might accept an order at a price below its total cost if it still covers variable costs and contributes to fixed costs. Furthermore, in periods of economic uncertainty, such as those marked by rising global inflation, businesses frequently scrutinize their variable costs like raw materials and energy to manage increasing input prices and maintain margins.⁵ Managing variable costs is an ongoing challenge for businesses facing supply chain disruptions and volatile input prices.⁴

Limitations and Criticisms

While highly useful for internal decision-making, variable costing has certain limitations. One significant criticism is that it does not align with Generally Accepted Accounting Principles (GAAP) for external reporting purposes. GAAP requires absorption costing, which allocates both fixed and variable manufacturing costs to products. This difference means companies must maintain two sets of records or adjust their figures for external financial statements.³

Another limitation is that variable costing can undervalue inventory on the balance sheet because it excludes fixed production overhead from inventory costs. This can lead to a less comprehensive view of a company's total expenses and might not accurately reflect the full cost of producing goods, especially for long-term pricing decisions.² Additionally, precisely categorizing all costs as purely fixed or variable can be challenging, as some expenses, known as semi-variable costs, exhibit characteristics of both. The Journal of Accountancy highlights that while variable costing provides insights into cash flow and break-even analysis, its non-conformity with GAAP for external reporting is a key drawback.¹

Variable costs vs. Fixed costs

The distinction between variable costs and fixed costs is fundamental in cost accounting and critical for business analysis. The core difference lies in how these costs behave in relation to production volume.

Variable costs are expenses that change in direct proportion to the level of goods or services a company produces. Examples include the cost of raw materials, direct labor wages, and production supplies. If a company doubles its output, its total variable costs will generally double. However, the variable cost per unit remains constant.

Fixed costs, conversely, are expenses that do not change with the level of production within a relevant range. These costs are incurred regardless of whether a company produces one unit or a thousand. Examples include rent for a factory, insurance premiums, executive salaries, and depreciation of machinery. While total fixed costs remain constant, the fixed cost per unit decreases as production increases, because the total fixed cost is spread over a larger number of units.

Confusion often arises because both types of costs contribute to a company's overall expenses. However, their distinct behavior impacts profitability analysis, break-even point calculations, and strategic decision-making. Companies analyze this relationship to understand their operational leverage and how changes in sales volume will affect their bottom line.

FAQs

What are common examples of variable costs?

Common examples of variable costs include direct materials (e.g., ingredients for food products, components for electronics), direct labor wages for production workers, sales commissions, packaging costs, and shipping expenses. These expenses typically increase as sales or production volume rises.

How do variable costs impact a company's profitability?

Variable costs directly affect a company's profitability by influencing the contribution margin for each unit sold. A higher contribution margin per unit means more revenue is available to cover fixed costs and generate profit. Effective management of variable costs can significantly improve a company's net income, especially as sales volumes fluctuate.

Why is it important to distinguish between variable and fixed costs?

Distinguishing between variable and fixed costs is crucial for accurate financial analysis, effective budgeting, and informed decision-making. This distinction helps businesses understand how changes in sales volume affect overall costs and profitability, allowing them to make better pricing strategies, production plans, and assess the financial impact of various business decisions.

Is variable costing used for external reporting?

Generally, variable costing is not used for external financial reporting. Accounting standards like Generally Accepted Accounting Principles (GAAP) require companies to use absorption costing, which includes both fixed and variable manufacturing costs in the cost of products for inventory valuation and cost of goods sold. Variable costing is primarily an internal management tool.

How do variable costs relate to economies of scale?

Economies of scale refer to the cost advantages that businesses gain due to increased output. While total variable costs increase with production, some efficiencies can emerge at higher volumes, such as bulk discounts on raw materials, which might slightly reduce the variable cost per unit. However, the primary impact of economies of scale is often on how fixed costs are spread over more units, lowering the average total cost.