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Variable cost is an accounting term that covers how much it costs to make and sell your products or services.
Knowing how variable costs work for your business can help you to set your prices and get a better idea of your profit margin.
Read on to find out how to calculate variable costs, plus how they differ from fixed costs.
The opposite of a fixed cost, a variable cost is an expense that fluctuates depending on the number of units produced.
The total variable cost of a product or service is the sum of the cost of all the things required to produce it, such as materials, packaging, and marketing.
Variable costs can go up and down depending on your business’s output.
For example if you produce more, your variable costs will go up. However when your production is lower, your variable costs will decrease.
If the variable costs for your business include raw materials, labour, and distribution costs, then you’ll need to spend more on these things as you make more sales. As a result your variable costs would be higher, which could affect your profit margin.
However if sales decrease, you won’t need to spend as much on making your product or distributing it, so your variable cost would be lower.
Business finance is complicated, so you should seek professional advice if you’re unsure of anything.
A variable cost can go up or down depending on your production levels. For example if you need to hire more staff to fulfil an increase in orders, your variable cost for labour would increase.
Here are some examples of the most common types of variable cost:
Working these out and adding them together can give you an idea of the total variable cost to create and sell a specific product or service.
When you work out variable costs, you can look at the total variable cost and the average variable cost.
The total variable cost shows you how much it costs to sell one type of product, while the average variable cost shows the combined total cost across several products.
The formula for working out the total variable cost is:
The formula for working out the average variable cost is:
As an example, you run a small business that sells handmade furniture and want to work out your variable costs.
Firstly, you want to work out the total variable cost for a set of kitchen chairs you sell for £500. The chairs cost £300 to make, advertise, and package.
You have six sets of the chairs with a variable cost per unit of £300, adding up to a total variable cost of £1,800.
You also want to work out the average variable cost for the kitchen chairs and another one of your products, a set of living room lampshades.
You have four sets of the lampshades with a variable cost per unit of £187.50, adding up to a total variable cost of £750.
The total variable cost for the two products is £2,550 (£1,800 + £750). This sum divided by the total number of units (10), leaves you with an average variable cost for the two products of £255.
Knowing your variable costs is helpful when it comes to setting your prices. Making sure your prices are significantly higher than your variable costs will allow your business to cover its fixed costs and ultimately make a profit.
For example, an online retailer sells handmade towels. They have a variable cost of £10 for each towel they sell and annual fixed costs of £15,000 (including insurance, rent, and fixed utilities).
If the retailer expects to sell 825 towels a year, they’ll need to contribute £18 per sale (£15,000 divided by 825) towards their fixed costs to avoid making a loss.
As a result, if they want to make a profit they’ll need to set their prices higher than £28 (£10 variable cost + £18 fixed cost contribution).
By understanding their variable costs and fixed costs, they can set their prices at the right level.
Many businesses use variable costs to work out their break even point – the amount of income they need to make to cover all their costs. Read our guide to working out your break even point for more information.
Variable costs for most businesses are likely to change frequently. This can make it harder to budget and make sure that your business is at least breaking even.
By understanding and keeping track of your variable costs, you can adjust your expenses or prices at the right time.
Staying up to date with changes in your production costs is important when it comes to setting your prices.
For example, if you run a wedding cake business and your flour costs increase by 40 per cent, you may need to reflect this in your prices to make sure you don’t make a loss.
Read our article on how to tell customers about a price increase for tips on tackling this sensitive issue.
Making these adjustments based on your expected number of sales and variable costs can help you to make the right business decisions.
A fixed cost is an expense that doesn’t change as a result of the number of products you produce and sell.
Some examples of fixed costs include:
It’s important to note that a fixed cost can still go up or down, for example your landlord could increase your rent. However, the cost of your rent is fixed in the sense that it won’t change if you make 50 sales one month and 250 the next.
As the name suggests, a semi-variable cost is somewhere in between a fixed cost and a variable cost.
Business production can involve both fixed costs and variable costs, so combining them into a semi-variable cost can help you to understand your overall costs.
To work out a semi-variable cost for something, you’ll need to add its total fixed cost to its total variable cost.
For example if you run a printing business, your printer will have a fixed cost based on how much it costs to insure and its depreciation of value over time.
The variable cost for the printer will depend on how much it costs to run and the cost of paper.
If the fixed cost of the printer is £4,000 a year and the total variable cost is £1,500, this adds up to a semi-variable cost of £5,500.
Do you have any unanswered questions about how variable costs work? Let us know in the comments below.
Conor Shilling is a Copywriter at Simply Business with over two years’ experience in the insurance industry. A trained journalist, Conor has worked as a professional writer for 10 years. His previous experience includes writing for several leading online property trade publications. Conor specialises in the buy-to-let market, landlords, and small business finance.
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