What is Variable Cost: How it’s Calculated for Small Businesses

If you’re a small business owner or looking to start your dream business, keeping track of expenses is a very involved aspect of maintaining a business. When looking at the production of your business’s goods and services, two types of expenses you will come across are fixed costs (FC) and variable costs (VC).

When weighing the differences between fixed vs variable cost, there are a few things to note. These costs can be nuanced. Some people understandably get confused because VC depends on output. This means that they fluctuate (hence, they are “variable“) depending on your level of production or sales. Fixed costs remain steady. Understanding fixed vs variable costs can provide valuable insights used to make sound financial decisions. So, let’s answer the question, “What are variable costs?” We’ll also share how to find variable costs, how to calculate variable costs, and why it matters to your small business. Read on!

What is variable cost?

Variable cost refers to expenses that change in proportion to how much your business produces or sells. These costs rise as production increases and fall as production decreases. They can be directly or indirectly related to the actual product or production process.

Examples include:

• Credit card transaction fees
• Distribution costs
• Labor costs
• Packaging expenses
• Production equipment
• Raw materials
• Sales commissions
• Shipping and freight costs
• Utilities

These expenses change based on your output and sales. If you understand these costs, you can be better prepared to make important financial decisions about pricing and profitability. These costs can also be quickly adjusted. So, if your business has cash flow problems, one option to relieve the pressure is to reduce or remove variable costs. 

Fixed vs variable costs

As the name suggests, fixed costs remain the same regardless of production output. They may change over time, like an increase in rent year-to-year, but they won’t change due to production volume. Fixed costs also more generally include indirect expenses. Common fixed costs are:

• Depreciation
• Employee salaries
• Insurance
• Interest expenses
• Property taxes
• Rent

Variable cost formula: How to calculate variable cost

The formula is: Total VC = Total output quantity x VC per unit of output

Next, we’ll break the calculation down step by step. But first, let’s discuss each component of the formula.

• Total output quantity: This part of the formula is simply the total number of units your small business produces.
• Variable cost per unit of output: The variable cost per unit refers to the costs of labor, materials, or other resources needed to produce just one unit of your product. One way to find this number is with the average variable cost formula, which is:

Average VC = Total VC / Total output

This formula will tell you how much, on average, it costs to produce a single unit of your product.

Multiply the average variable cost per unit by the number of units you produce or sell; you arrive at your total variable cost. Let’s say, on average, it costs $2.50 to make one pizza (a single unit). If you sell 1,000 pizzas monthly, your variable cost is $2,500.

Here’s what the formula looks like in action for this pizza example:

VC = $2.50 (VC per unit) x 1,000 (Number of units) = $2,500

To find the variable cost for one week, you can divide the monthly variable cost by the number of weeks in a month. Assuming a standard month has approximately four weeks, the calculation is as follows:

Weekly VC = Monthly VC / 4 weeks = $2,500 / 4 = $625

As you can see, the variable cost for that week will be $675. But remember: this amount, in reality, will change based on how many pizzas are ACTUALLY sold each week. If the business sells more, this type of cost will go up. If it sells less, it will go down.

How to find average variable cost

Despite their names being comparable, average variable cost and variable cost represent different things. Average VC shows production over time and compares VC to what has been produced. In contrast, the other term defines the VC for a single product. The two types may not always be the same amount.

Here’s how to calculate the average variable cost:

Average VC = Total VC / Total output

For example, if your total VC is $20,000 per quarter and your output is 4,000 pizzas, your average VC is $10.

Variable cost vs marginal cost

Business owners commonly confuse marginal and variable costs – and there’s good reason for it. We’ll take a minute to explain the difference.

Marginal cost is the overall change in total production costs when a business increases its production by one unit. At first glance, it might be hard to tell the difference between marginal and variable cost. But there’s a key difference – marginal cost accounts for both fixed and variable costs. Whenever there is a change in production costs, marginal costs will exist. For this reason, marginal costs coexist with variable costs. 

This formula calculates marginal cost:

Marginal cost = change in cost ÷ change in quantity

Questions about any of these bookkeeping tasks for your business? Schedule a free bookkeeping consultation with a Block Advisor pro.

Why a variable cost analysis is important

Why is understanding this topic so important for your business? Here are some crucial aspects of your business that are affected by these costs:

1. Operating leverage

Operating leverage looks at the combination of variable and fixed costs. If your company has high fixed costs and low VC, you’ll have high operating leverage. You’ll have low operating leverage if the opposite is true.

Increasing sales doesn’t dramatically raise profitability if your business has significant variable expenses because your VC will increase with higher sales. Your company will depend on a large sales volume to help increase profitability and pay for your high fixed costs if it has low VC.

2. Contribution margin

Variable costs are also a direct input when calculating contribution margin. It’s a good indicator of how each product unit contributes to overall profits. Contribution margin refers to the difference between a company’s sales revenue and its variable costs. This difference goes directly toward paying for fixed costs. Once fixed costs are paid, the remaining contribution margin adds to your bottom-line profit. This means that VC helps to determine the break-even point. The contribution margin funds should cover fixed expenses – and profit is the remaining amount after you deduct fixed costs.

3. Break-even point

Break-even point is calculated by dividing fixed costs by the contribution margin. So, your company can look at its VC analysis to determine the number of units you need to sell to break even. Selling past the break-even point will usually result in a profit. Use the break-even point calculation to determine the minimum number of units you need to sell to make a profit. Other helpful calculations include determining your gross margin, profit margin, and net income.

4. Pricing

A variable cost analysis can also help guide your overall pricing strategy. You’ll better understand what you need to charge per unit to make a profit. Analyzing these costs will help ensure you set prices that cover production expenses to generate a profit. Your small business can identify how changing product output can change profit calculations by performing this analysis.

5. Margin calculations

Different margin calculations like gross margin, profit margin, and net income often include variable and fixed costs. Knowing your company’s VC will not only help you better understand these metrics but also give insight into how increasing or decreasing your output can impact these calculations.

Get small business support from Block Advisors

Understanding these costs is just one aspect of your business financials that you should have a firm grasp on. However, keeping track of these performance indicators and analysis methods can get complicated. A lot goes into managing your business, so whether you’re just getting started or you’re a seasoned owner, Block Advisors is here to help.

Get back to doing what you love and let our experts lighten your load, in person or virtually, year-round – as always – backed up by the Block Advisors guarantees. Our taxes, bookkeeping, payroll, and incorporation services are designed with small business owners like you in mind.

Speak with a certified small business pro today!

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This article is for informational purposes only. The content may not constitute the most up-to-date information and should not be construed as legal advice.