The total expenses accrued by all businesses involve accumulating costs or money required to perform business activities. Successfully calculating variable cost is one of the most significant factors when determining the success of an organization.
Accounting teams will separate costs into two categories: fixed and variable costs. Today, we will focus on variable cost, and by the end, you will feel confident about calculating the variable cost and maximizing your cash flow management.
Definition of variable cost
Variable cost represents materials or other inputs acquired by a business. These costs directly correlate to the number of services or goods produced. Variable costs will increase or decrease depending on a company’s production or sales volume. Consequently, these costs will rise as production increases and fall as production decreases.
The two categories in cost accounting are variable and fixed cost. These accrued costs encompass the total cost of running a business. For instance, fixed cost differs in that these numbers stay the same regardless of the company’s output. Examples of fixed costs would be rent, payroll, business insurance, etc.
Common Variable Costs
When we look at variable costs, these numbers fluctuate week after week, depending on the sales volume. Below are examples:
- Raw Materials are the materials needed within a manufacturing environment to produce the final product.
- Transaction Fees are an expense that businesses must pay every time there is a credit card purchase or a bank transfer is sent.
- Utility Costs include expenses such as electricity, gas, water, etc. Note there are utilities such as internet connectivity which are considered fixed expenses. This is because they don’t change month-to-month and are independent of revenue or production volume.
- Commissions are additional salaries paid to someone completing a sale or even service work. Some businesses allocate a percentage of the total amount sold to each sales associate that assists in closing the deal.
- Labor can be a variable cost if the workers are paid hourly or based on each unit completed.
- Packaging and Shipping costs will vary depending on the amount of inventory sold.
Variable Cost Formula
Under the cost accounting umbrella, variable cost is likely the most abstract category. These numbers change month after month and often create much confusion.
The total variable cost equals the number of units produced multiplied by the variable cost per unit. See formula below:
Here is how to calculate this formula:
- First, identify all costs associated with the specific production of a single product unit.
- Second, add all of these costs together, so you have the total price for each unit.
- Finally, the total variable cost is multiplying the price per unit by the number of units produced.
Average Variable Cost
The average variable cost (AVC) takes the total cost per unit divided by the number of units. AVC explains how costs from increasing output fall, become flat, and finally increase as production costs outweigh benefits.
The formula for average variable cost requires the calculated total variable cost to be complete.
Furthermore, one must divide the total variable costs from the accounting period by the total number of units produced.
Importance of Variable Costs
If a business has a large proportion of variable costs in its cost structure, most of its expenses will vary in direct proportion to revenues. Therefore, businesses are more equipped to weather a sales decline than a company with a high fixed-cost balance.
Learning how to calculate variable cost will help you accurately forecast expenses as a whole and identify ways to bring down your total costs. For instance, you might find that you can get materials from another supplier for less. These savings will bring down your cost per unit, which directly decreases your total costs.
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