What Is Variable Cost? Types, Examples, & How to Calculate

A deep understanding of variable costs is essential when starting a new business or seeking to improve current profit margins. Many business owners make the mistake of looking at all costs the same way, leading to misclassification and misunderstanding of business expenses. To better grasp expenses and how they impact your business, you can divide costs into two categories: fixed costs and variable costs.

While fixed costs remain constant, variable costs change depending on a business’s output. And with the OECD predicting US economic growth to be just 0.5% in 2023, many companies will be looking at ways to reduce variable costs and retain additional revenue.^[1]OECD. “Economic Forecast Summary (November 2022).” Accessed July 12, 2023. However, even seasoned business owners struggle to classify variable and fixed costs. This guide explores variable costs, how to calculate them, how they impact growth, and a host of related topics.

What Is a Variable Expense?

A variable expense is a cost that proportionally corresponds to the amount of output a business produces. As output increases, variable cost increases; likewise, if output decreases, so does variable cost. If your business has high variable costs, it will likely have lower margins, as each additional unit of production is correlated to a high variable cost.

For example, if you own a business producing piping for plumbers, a variable cost will be the piping material. This cost only incurs when you increase production—you only need to purchase more piping material if you receive additional orders to produce piping.

Different Types of Variable Costs

Various expenses fall under the variable cost umbrella. Let’s explore some common types of variable costs:

The above costs increase as production increases, making them variable costs. Let’s explore how a couple of the above variable costs work in context:

Example 1: Sales Commissions

A sales commission is an excellent example of a variable cost; it increases as output increases. The more your salespeople sell, the higher your commission costs will be. Businesses must decide on an appropriate commission structure to incentivize salespeople without creating a significant variable cost burden.

Example 2: Credit Card Processing Fees

When you process credit cards and debit cards in your business, you pay a fee for credit card processing services. Many credit card processors offer a per-transaction commission structure, meaning instead of paying a monthly access fee, you pay a commission on each charge.

As a result, these costs vary directly with your sales—the more sales transactions you process, the higher your processing fees. Finding a merchant account provider with reasonable fees can help your business reduce its variable costs.

How to Calculate Variable Cost

If you want to assess your overall variable costs, you need to calculate the “total variable cost.” Identify your variable costs—such as sales commissions, shipping charges, credit card processing fees, etc.—and assign them to the relevant product or service. Next, multiply the total quantity of output by the variable cost per unit of output.

Total Variable Cost Formula

The total variable cost formula is relatively straightforward:

Total Variable Cost = Total Quantity of Output x Variable Cost Per Unit of Output

Variable Costs Examples

Calculating total variable cost is simple if you have the numbers available. Let’s explore two basic examples of variable costs below:

Construction Variable Cost Example

Let’s look at some of the variable costs involved in constructing a house:

	1 House	2 Houses	5 Houses	0 Houses
Raw Materials	$40,000	$80,000	$200,000	$0
Contract Labor	$30,000	$60,000	$150,000	$0
Total Variable Cost	$70,000	$140,000	$350,000	$0

Note: The construction process will contain more variable costs than listed in the above table—this is for basic informational purposes only.

Manufacturing Variable Cost Example

Let’s explore an example of a manufacturing company. This company builds industrial machines and pays salespeople a commission for selling products to businesses:

	1 Machine	2 Machines	5 Machines	0 Machines
Raw materials	$1,000	$2,000	$5,000	$0
Delivery expenses	$200	$400	$1,000	$0
Sales commission	$500	$1,000	$2,500	$0
Total variable cost	$1,700	$3,400	$8,500	$0

Note: A manufacturing process will contain more variable costs than listed in the above table—this is for basic informational purposes only.

Average Variable Cost

While the two examples above outline variable costs that remain uniform regardless of how many products are produced, this isn’t always the case. In some instances, the average cost of inputs may decrease as you produce more products. For example, if you need to purchase raw materials to build a home, the wood for the framing may cost less on average if you’re building five homes than if you’re building a single home—suppliers often offer bulk purchase discounts.

Likewise, average variable costs may change over time as the price of inputs changes. If a salesperson receives a raise on their commission rate halfway through a year, the average variable cost will increase if they continue to sell products.

Therefore, calculating average variable cost will help you determine variable expenses across multiple units of products. The formula for calculating the average variable cost is:

Average Variable Cost = Total Variable Costs/Total Output

So, why is it critical to monitor your average variable costs? Businesses analyze the average variable cost to determine the most efficient production volume. If the average variable cost rises beyond a certain level of output, the business might opt to halt production.

Fixed vs. Variable Costs

Unlike variable costs, fixed costs don’t change when you increase production. So, what are some examples of fixed costs?

Let’s explore a fixed cost in context. If your business manufactures t-shirts, you may hire extra staff to produce t-shirts if a large order arrives—this is a variable cost. However, if you have an office manager on a salary, regardless of how many shirts are in production, their salary is a fixed cost.

Marginal vs Variable Costs

While fixed and variable costs are the two primary costs associated with production, there’s another cost worth considering: marginal cost. Marginal cost refers to the expense associated with producing just one additional unit. For example, if you run a car factory that manufactures 20 cars annually, the marginal cost will be the expenditure incurred to produce the 21st car.

Marginal cost is equal to the change in the overall cost of production divided by the change in quantity. As fixed costs don’t change in the short-term, marginal costs are closely linked to variable costs.

Why Is a Variable Cost Analysis Important?

Understanding variable costs is essential because it has real implications for business owners. Let’s explore four of the primary reasons it’s critical to analyze your variable expenses:

A break-even point is the moment revenue meets the cost of production. Due to the nature of fixed costs and variable costs, your business will lose money until it reaches a specific number of units that generate enough revenue to cover all costs. As businesses exceed this production level, they often generate profit.

Lower fixed costs result in a lower break-even point, making it easier for businesses to generate profit. Therefore, transferring fixed costs into variable costs can reduce the unit production required to exceed the break-even limit.

Understanding variable costs makes it easier to price your products correctly. Many businesses use the “Variable Cost-Plus Pricing” strategy, which involves adding a markup to variable costs to determine the price of a product. This pricing strategy assumes the markup will also cover the fixed costs.

Essentially, a business must price its goods or services in a way that not only covers the total costs (both variable and fixed) incurred in production but also allows for a profit margin. Therefore, businesses often calculate their total variable cost per unit to determine the minimum price at which a product can be sold to break even.

Variable costs impact inputs in various ways. Firstly, businesses may look to other suppliers with lower prices if they want to decrease variable costs. Secondly, businesses may also invest in fixed costs to reduce the variable cost burden, leading to a change in production inputs.

Lastly, variable costs impact future plans for a business and its production. Whether it’s deciding to purchase assets to reduce variable costs or reducing risk by renting machinery instead of buying it, many decisions for the future are made with variable costs in mind.

How Do Variable Costs Impact Growth and Profitability?

Understanding variable costs and their impact on profitability is critical for aspiring business owners. As illustrated previously, focusing on variable costs instead of fixed costs results in a lower break-even point. This makes it easier for a business to attain profitability, as it does not need to produce as many goods to meet its sum of fixed and variable costs.

However, since variable costs increase proportionally with an increase in production, they can reduce profit margins if a business significantly increases its production. An operation with low variable costs and high fixed costs can achieve large profit margins if its revenue spikes.

In summary, while higher variable costs make growth and profitability more attainable, they also limit the large-scale returns associated with businesses focused on fixed costs.

Factors to Consider When Assessing Variable Costs

When you assess variable costs within your business, keep the three following factors in mind:

1. The relevant range of raw costs

The relevant range of raw costs relates to differences in expenses often appearing when you bulk purchase goods. For example, the cost of raw materials may decrease as a business increases its purchase volume.

Likewise, some forms of labor may have a relevant range. For example, if workers need to work overtime when a business increases production, the business may have to pay an overtime premium on top of the worker’s standard wage rate.

2. Degree of operating leverage

With variable costs, there’s a lesser degree of leverage, which results in decreased risk. However, while risks are lower as these costs only increase with rising production, they simultaneously limit the potential growth opportunities for a business. Conversely, fixed costs carry more risk but provide a higher degree of operating leverage, offering more upside potential for a business.

Let’s consider a practical example. Purchasing a new piece of machinery incurs a substantial upfront cost, increasing the business’s break-even point. However, it also means the business will benefit from higher profit margins if the business’s ability to sell products skyrockets. This happens because the average fixed cost per unit decreases as production rises, leading to expanded profit margins.

Alternatively, suppose a company opts to rent the machinery on a per-unit basis. In that case, it will have a lower break-even point, but if production skyrockets, the company will need to continue paying the per-unit production rental fee, diminishing the potential profit from increased production.

All of this means increasing leverage by focusing on overhead costs has the potential to yield large returns for a business. However, this only works if a business’s output reaches levels to offset the initial investment in purchasing the machinery.

3. Contribution margin

A contribution margin is a per-unit or gross margin a business generates after subtracting variable costs from the unit’s sale price. Lower variable costs will increase the contribution margin associated with production. Once a business determines the contribution margin, it will pay its fixed costs, leaving the remaining money as profit.

Final Thoughts on Variable Costs

An understanding of variable costs, their relation to fixed costs, and their impact on your business remains essential if you want to succeed in the modern economy. Moreover, understanding variable costs can help in the efficient management of your payment operations, Fortunately, by opting for zero-cost credit card processing, you can lower your variable costs (and increase your revenue) today!

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