Variable cost

Definition

Variable costs are expenses that vary in direct proportion to the level of production or business activity.

What are variable costs?

In other words, they are costs that change with the quantity of goods or services a business produces. As production increases, variable costs also rise, and as production decreases, variable costs decrease.

Examples of variable costs:

1. Raw materials: The cost of raw materials needed to manufacture products is a classic example of a variable cost.
2. Labour: In some industries, especially those with a piece-rate payment system, labour costs are considered variable. 
3. Utilities: In many cases, the cost of utilities is tied to production levels. A factory using more energy to produce more goods is an example.
4. Direct labour: For industries where labour costs are directly tied to production, the wages of production workers can be considered a variable cost.
5. Sales commissions: In businesses where salespeople receive commissions based on the number of units sold, this is a variable cost.

Since variable costs are directly tied to production levels, they are often considered more controllable in the short term. This means that a business can adjust its production levels to manage variable costs.

Variable costs are typically accounted for in a company’s income statement as direct costs of goods sold. They are matched with revenue to determine gross profit.

Variable cost vs. average variable cost

Variable cost refers to the total expenses that change in proportion to a company’s production or sales volume, such as raw materials and direct labor. These costs increase as production rises and decrease as production falls. Average variable cost (AVC) is the variable cost per unit of output, calculated by dividing the total variable cost by the number of units produced.

While variable cost reflects the overall expenses related to varying production levels, AVC provides a per-unit measure, helping businesses understand the cost efficiency of their production processes and make pricing or production decisions based on per-unit costs rather than total costs.

Variable costs vs. fixed costs

Variable costs fluctuate with production or sales volume, such as raw materials, direct labor, and utilities. These costs increase as production rises and decrease as production falls. Fixed costs, on the other hand, remain constant regardless of production levels. Examples include rent, salaries, and insurance.

Fixed costs must be paid regardless of output, providing stability but also creating financial obligations even during low production periods. Understanding the balance between variable and fixed costs helps businesses manage budgets, set prices, and make informed decisions about scaling production to maintain profitability and operational efficiency.

Example of variable costs

Let’s consider a company that manufactures bicycles. Some of the variable costs associated with producing bicycles include:

1. Raw materials: The cost of steel, rubber, and other materials used in manufacturing the bicycle frames, wheels, tires, and other components. As the company produces more bicycles, the cost of raw materials increases proportionally.
2. Direct labor: The wages paid to assembly line workers who assemble the bicycles. The more bicycles the company produces, the more hours of labor are required, leading to higher labor costs.
3. Utilities: The cost of utilities used to power the manufacturing equipment and facilities. As production levels rise, the consumption of utilities increases, resulting in higher utility costs.

These costs vary directly with the level of production. If the company produces fewer bicycles, variable costs decrease accordingly. Conversely, if production increases, variable costs also increase.