From the viewpoint of management, variable expenses are easier to adjust and are more fob accounting in their control, while fixed costs must be paid regardless of production volume. Unlike fixed costs, these types of costs fluctuate depending on the production output (i.e. the volume) in a given period. Since costs of variable nature are output-dependent, the costs incurred increase (or decrease) given varying production volumes. A good variable expense ratio is one that leaves you enough sales revenue to cover your fixed expenses with a comfortable target profit margin. Alternatively, a company’s variable costs can also be calculated by multiplying the cost per unit by the total number of units produced. Variable costs, or “variable expenses”, are connected to a company’s production volume, i.e. the relationship between these costs and production output is directly linked.
What Is the Formula for Total Variable Cost?
A variable expense is an expense that is directly tied to production levels. To determine the variable cost ratio for that month, we simply divide the variable cost ($1,000) by the sales revenue ($20,000). To calculate the variable cost ratio of the backpack, we divide the variable cost ($10) by the sales revenue ($100). If a higher volume of products is produced, the amount of delivery and shipping fees also incurred increases (and vice versa) — but utility costs remain constant regardless. By securing better deals, longer credit terms, or bulk purchase discounts, companies can achieve significant reductions in their material costs, which constitute a large part of variable costs for many businesses.
How to Calculate the Variable Cost Ratio
The Variable Expense Ratio allows businesses to carry out a cost-volume profit, or CVP analysis, with great accuracy. This, in turn, allows them to set reasonable prices for products as well as production goals. Some analysts like to calculate the variable expense ratio by subtracting the contribution margin from the number one. To return to the example of the pencil factory — the cost of wood and graphite will go up as the factory increases production because making more pencils requires more wood and graphite. This article will explore how the variable expense ratio is calculated and where it’s used. Keep reading to learn more about why this is such an important business metric.
- Cutting costs by sourcing lower-quality raw materials can reduce variable costs in the short term but might harm the brand’s reputation and customer trust in the long run.
- By reducing its variable costs, a business increases its gross profit margin or contribution margin.
- Implementing knowledge of variable costs can lead to improved decision-making and better business strategies.
- This is an invaluable planning tool since it allows management to predict exactly what its total expenditures will be.
This, in turn, will raise the cost per unit, leading to higher variable costs for businesses reliant on that material. The selling price for a single product is $250, with a per-unit variable cost of $100 to manufacture it. Generally speaking, high variable costs typically mean you’ll need fewer sales to break petty cash book: types diagrams and examples even, since you’ll have fewer fixed costs. A low variable expense ratio is better for businesses that have higher fixed expenses.
Variable Cost Per Unit Formula
The key is to understand what you’re really trying to measure and why, so you can decide for yourself how precise you need to be in making sound financial decisions for your company. Imagine that you lease a small pottery studio where you and two employees create handmade flower pots to sell in an exclusive local boutique.
However, orders of greater than 1,000 pounds of raw material 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). However, variable costs have limitations, such as their unpredictability during sudden changes and potential neglect of long-term effects.
Direct Labor
The average variable cost, or “variable cost per unit,” equals the total variable costs incurred by a company divided by the total output (i.e. the number of units produced). 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 may not make sense to expand.
A good variable ratio is one that covers all variable expenses while leaving enough revenue to cover fixed expenses as well as earn a profit. As you can see, variable costs are directly tied to production levels, with costs rising along with production. To determine the contribution margin, simply use the calculation 1 – variable cost ratio. You can then multiply the result by 100 to express the result as a percentage. So, in the case of the hiking backpack, the contribution margin would be 90%. This is an invaluable planning tool since it allows management to predict exactly what its total expenditures will be.