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September 22, 2020
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Variable costs are business expenses that change depending on production volume. Variable costs are tied to production output, meaning that if a business increases its production, the variable costs also increase. Similarly, if the production decreases for any reason, the variable costs will become smaller.
Expenses like raw materials, sales commissions, packaging, and utility costs can all be classified as examples of variable costs.
A company will have both fixed costs as well as variable costs. Fixed costs remain the same regardless of the production volume, unlike variable costs.
A fixed cost is an expense a company has that’s unrelated to production. Fixed costs include costs like rent, office supplies, salaries of the employees, and insurances.
While these costs can also be negotiated and changed over time, the changes are not directly related to the production volumes.
Even if a paper clip factory would have to reduce their paper clip production for a quiet quarter, it would still need to pay its fixed costs, like factory and office rents.
On the other hand, the company would save on variable costs like the metals and factory utility costs, instead.
While variable costs can be industry and business-specific, some of the most common variable costs in a business operation include:
Let’s take a look at a real-life example of how variable costs can influence the profit margins of a small business.
We can assume it costs a bakery $6 to make one loaf of bread: the raw materials (flour and yeast) cost $1 and the baker pays $5 for the direct labor involved in making the bread.
It’s easy to see how the variable costs increase the more bread loaves are made:
|1 loaf of bread||2 loaves of bread||5 loaves of bread||10 loaves of bread|
|Cost of raw materials (flour, yeast)||$1||$2||$5||$10|
|Total variable cost||$6||$12||$30||$60|
In this example, the total variable cost per unit is $6 per loaf of bread. The more bread the bakery sells, or the higher the quantity of output, the higher the variable cost will be. And, similarly, during a quieter week or month, when not many people want to buy bread, the variable costs decrease.
A company’s profit is calculated by subtracting the costs from the overall made revenue (the number of sales made, or in this example, the amount of bread sold). This means that by reducing its costs, it can make a higher profit.
Since it’s more challenging to reduce fixed costs, companies often look at ways to minimize their variable costs instead.
The bakery could sell their bread for $15 per unit, meaning that the gross profit per bread loaf will be $15 – $6 = $9. To get an idea of the net profit, the fixed costs are now deducted from the gross profit. Let’s say the bakery’s fixed costs are $500 a month including rent, insurance, and utilities. This means that the monthly profit could be calculated like this:
|Amount sold||Total variable cost||Total fixed cost||Total cost||Sales||Profit|
|20 loaves of bread||$120||$500||$620||$300||– $320|
|50 loaves of bread||$300||$500||$800||$750||– $50|
|55 loaves of bread||$330||$500||$830||$825||– $5|
|100 loaves of bread||$600||$500||$1100||$1500||$400|
|250 loaves of bread||$1500||$500||$2000||$3750||$1720|
The bakery will operate at a loss if it sells under 55loaves of bread every month. This means that there isn’t enough income generated to cover all the occurring expenses and costs.
To break even, or cover the costs with the generated sales, the company needs to sell roughly 56 loaves of bread. And anything above that will be considered as profit. In order to increase its profits, the company needs to bring its costs down without impacting the level of service or quality of the baked goods.
Profits can be increased either with a higher gross profit margin (more bread needs to be sold) or by increasing its contribution margin. A contribution margin is a calculation that lets the business see how much overall sales revenue and profit can be earned from each loaf of bread:
(Sales – Variable costs) / Sales
For our example bakery, the contribution margin is ($15 – $6) / $15 = 0.60, or 60%. This means that if the bakery can find a better deal and get their flour for cheaper or decrease the labor costs, reducing the variable costs to $4, the contribution margin will grow to ($15 – $4) / $15 = 73%.