Variable Cost: Definition with Examples
Updated: Nov 1, 2022
What is Variable Cost?
Variable Costs are expenses paid by a company that changes based on the company's productivity. The more a company produces, the higher its variable costs will be; the less a company makes, the lower its variable costs.
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Variable Cost Key Points
Variable Costs change depending on the activity level of a company.
Total Variable Costs = Cost Per Unit x Total Number of Units.
Variable Costs are the costs of expansion and growth in business.
Companies with a high proportion of variable costs relative to fixed costs are considered to be less volatile and have better investments.
Variable Cost Explained with Examples
All businesses incur expenses, some are fixed, and some change. The costs that change, are known as variable costs.
Variable costs are important to understand, as the changes can heavily impact productivity, and most importantly profit.
When a company produces more products, its variable costs would also increase [1]. Below is an example of Comfy Sofas LTD, a company that produces the comfiest sofas you have ever sat on!
As we can see from the chart above, for every extra 100 comfy sofas (Units) produced, the Total Variable Costs increased by £10,000.
This is to make these extra 100 sofas and increase the overall amount of sofas you produce. The company will have to purchase additional raw materials such as Fabrics, Wooden panels, Fabric dye and other sofa-making materials.
How Variable Cost Works
You can think of variable costs for most companies as the cost of growth. The more products a company sells, the more they grow in reputation and brand awareness. This means more consumer demand for the company's products.
This is where Variable Costs come into play. The more demand there is for a company's products, the more that company will want to produce to maximise its profitability.
The more that the company's demand grows, and as long as the company grows with this demand by producing more products, the larger the Variable Costs for this company will be.
Think about some of the biggest and most famous brands in the world, companies such as Apple, Nike or Sony.
Each of these will have its own set of variable costs that will include:
Raw materials
Direct labour—wages for the people manufacturing goods hands-on
Credit card and payment processing fees
How Do You Calculate Variable Cost?
To calculate the variable costs for a company, all you need to do is follow a simple formula displayed below:
Let's use this formula to calculate the total variable costs for a company that wants to sell 375 jumpers at £50 each at a festival:
CPU (Cost per Unit) = £50
TNU (Total number of Units) = 375
50 x 375 = £18,750 TVC (Total variable Costs)
Variable Costs vs Fixed Costs
If Variable Costs change based on a company's level of activity, then Fixed costs can't be too hard to figure out.
Fixed costs are expenses that do not change no matter the activity level of the company, examples of fixed and variables for a manufacturing business would be:
Examples of fixed costs for manufacturing
Equipment maintenance
Indirect labour—supervisor and administrator wages
Insurance
Business licenses
Warehouse rent
Examples of variable costs for manufacturing
Raw materials
Direct labour—wages for the people manufacturing goods hands-on
Credit card and payment processing fees
Outgoing freight
To be profitable, a company will need to work out its total Fixed and Variable costs and then cover them with product sales. Once they have covered these two sets of costs, they can be considered profitable. [1]
This is called breakeven analysis, BE analysis is used to determine the amount of revenue or the required products that need to be sold to cover total costs.
It follows a simple formula that is as follows:
What It Means for Retail Investors
As investors, we care about the costs a company incurs. This is all to do with a company's profitability. The more profitable a company is, the higher its share value of that company.
It's not uncommon for investors to add variable costs in their trading journal. It helps them keep track of important metrics, and make better-informed trading decisions.
Now you can see the power of understanding basic accounting when looking to buy and sell shares on the stock market.
In general, companies with a high proportion of variable costs relative to fixed costs are considered to be less volatile and, therefore, better investments, as their profits are more dependent on the success of their sales.
This means that when looking for your next share to buy, remember this short checklist before making your decision:
Is the company profitable? (look at past years to see the trend)
Do they have a higher proportion of variable costs than fixed costs?
Is the product the company is selling innovative and forward-thinking? (there's no point investing in a company whose product doesn't have a future)
If the company in question hits all three of these points, you may be on a good opportunity.
(most of the accounting/financial information for each company can be found on yahoo finance)
Sources:
[1] Corporate Finance Institute (2019). "Variable Costs" Accessed 16 Aug. 2022
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