Every business encounters a frustrating truth in the early stages of growth: more money, more problems.
This seems counterintuitive-wouldn’t it be a good thing if sales and revenue increase? How can greater profits become a potential problem?
In short, it all boils down to the fact that the more you sell, the more money you need to spend. This includes marketing and sales activities to attract more customers, the production cost of more goods, and the time and money required for new product development.
This sales/expense ratio is called variable cost and is something that every business owner should understand, but online suggestion lists and action plans usually assume that readers have an inherent understanding of the concept, rather than provide a workable definition.
In this article, we will clarify the confusion of variable costs: here is what you need to know about variable costs, how to calculate them, and why they are important.
What is variable cost?
Variable cost is the sum of all labor and materials required to produce a unit of product. Your total variable cost is equal to the variable cost per unit multiplied by the number of units produced. Your average variable cost is equal to the total variable cost divided by the number of units produced.
Let’s examine each of these components in more detail.
Variable cost per unit
Variable cost per unit is the amount of labor, materials, and other resources required to produce a product. For example, if your company sells a set of kitchen knives for $300, but each set of kitchen knives requires $200 to create, test, package, and market, then your unit variable cost is $200.
Number of production units
The number of units produced is exactly what you expect-it is the total number of products produced by your company. Therefore, in the tool example above, if you manufacture and sell 100 sets of tools, then the total number of tools you produce is 100, the variable cost of each tool is US$200, and the potential profit is US$100.
Variable cost formula
To calculate variable costs, multiply the cost of producing a unit of product by the total number of products you create. The formula looks like this: total variable cost = cost per unit x total number of units.
Variable costs are so named because they increase or decrease as you produce more or less products. The more units you sell, the more money you make, but some of the money will need to pay for the production of more units.So you need to produce more The actual profit of the unit.
Moreover, because each unit requires a certain amount of resources, the greater the number of units, the higher the variable cost required to produce them.
However, variable costs are not “problems”-they are more like a necessary evil.They play a role in multiple bookkeeping tasks, your All Variable costs and Average Variable costs are calculated separately.
Total variable cost
Your total variable cost is the sum of all variable costs associated with each individual product you develop. Calculate the total variable cost by multiplying the cost of producing a unit of product by the number of products you develop.
For example, if the cost of producing 1 product is 60 USD and you have already produced 20, the total variable cost is 60 x 20 USD, or 1,200 USD.
Average variable cost
Average variable cost uses total variable cost to determine the average cost of producing a unit of product. You can calculate it with the following formula.
Total variable cost and average variable cost
If you use your total variable cost to find the average variable cost of a unit, do you already know how much it costs to develop a unit of product? Can’t you go backwards and simply divide your total variable cost by the number of units you own? unnecessary.
Although the total variable cost shows how much you paid to develop each product unit, you may also have to consider products with different unit variable costs. This is where the average variable cost comes in.
For example, if you have 10 pieces of product A with a variable cost of 60 USD/piece and 15 pieces of product B with a variable cost of 30 USD/piece, you have two different variable costs—60 USD and 30 Dollars. Your average variable cost reduces these two variable costs to a manageable number.
In the example above, you can add the total variable cost of product A (60 USD x 10 units, or $600) and the total variable cost of product B (30 x 15 units, or 450 USD), and then Divide by to get the average variable cost. Divide the sum by the total number of units produced (10 + 15, or 25).
Your average variable cost is ($600 + $450) ÷ 25, or USD 42 per unit.
Variable and fixed costs
The opposite of variable cost? Fixed costs. Fixed cost It is a cost that does not change with the number of products you produce.
Some common fixed costs include renting or leasing buildings, utility bills, website hosting, commercial loan repayments, and property taxes.
Worth noting?These fees are not stationary — This means that your rent may increase year by year. Instead, they remain unchanged only in terms of product production.
To calculate the average fixed cost, use the following formula:
Variable costs and fixed costs are essential to fully understand the cost of producing goods and the profit remaining after each sale.
What is the variable cost ratio?
Variable cost ratios enable companies to ascertain the relationship between variable costs and net sales. Calculating this ratio helps them consider increased revenue and increased production costs, so that the company can continue to grow at a steady rate.
To calculate the variable cost ratio, use the following formula:
Let us put it into practice. If you sell an item for $200 (net sales), but the production cost is $20 (variable cost), then you divide $20 by $200 to get 0.1. Multiply by 100, and your variable cost ratio is 10%. This means that for every item sold, you will get a 90% return, of which 10% is used for variable costs.
At the same time, combining variable costs and fixed costs can help you calculate Break-even point — The point at which the production and sales of goods are reset to zero through the combination of variable costs and fixed costs.
Consider our example above again. If the variable cost of a $200 item is $20 and the fixed cost is $100, then your total cost now accounts for 60% of the value of the item sold, leaving 40%.
general speaking? The higher your total cost ratio, the lower your potential profit. If this number becomes negative, you have exceeded the break-even point and you will start to lose money every time you sell.
So, what is considered to be the variable cost of the business?
Some of the most common variable costs include physical materials, production equipment, sales commissions, employee salaries, credit card fees, online payment partners, and packaging/shipping costs.
Variable cost example
- Physical material
- Production equipment
- sales commission
- Employee salary
- Credit card fee
- Online payment partners
- Packaging and shipping costs
Let’s examine each one in more detail.
These may include parts, fabrics, and even food ingredients needed to make the final product.
If you automate certain parts of product development, as the product line expands, you may need to invest in more automation equipment or software.
The more products your company sells, the more commissions you pay to salespeople to win customers.
The more products you create, the more employees you may need, which also means a larger payroll.
Credit card fee
Companies that receive credit card payments from customers will incur higher transaction fees as they provide more services.
Online payment partners
Apps like PayPal usually charge businesses a fee for each transaction, so customers can check their purchases through the app. The more orders you receive, the more you pay to the app.
Packaging and shipping costs
You may have to pay per unit to package and ship your products, so more or fewer shipping units will cause these costs to change.
Expect the unexpected
Although variable costs, total variable costs, average variable costs, and variable cost ratios are often complex on the surface, these terms simply refer to changes in the nature of the cost of producing new products as the business grows.
By understanding the nature of these costs and how they affect your current and projected revenues, you can better prepare for changing market forces and reduce the impact of variable costs on your bottom line.