Understanding variable costs and their potential impact on a business is essential for any entrepreneur looking to start or grow a company.
Variable costs are expenses that rise and fall in proportion to a business’s activity level, such as production or sales volume. Monitoring these expenses — which can include anything from materials to staff overtime — may help a company boost profit margins and set accurate price points.
Use this guide to learn more about variable costs and how they can help inform financial decisions.
In a business context, a variable cost is an expense that varies depending on production or sales levels. Unlike fixed costs, which remain the same regardless of output, variable costs may change based on business activity.
Variable costs are also pivotal in determining a business's gross profit margin, a key indicator of financial health. Below are some key characteristics of variable costs:
Take a restaurant, for example. During busy times and seasons, it may need more waiters and cooks. The cost of having more staff goes up when there are more customers, which makes staffing a variable cost that can change with demand.
Used for determining pricing strategies, variable costs impact the cost of goods sold and, in turn, the profit margin of each unit sold.
Unlike fixed costs — such as rent, utility bills, and other recurring payments that remain the same whether a business has a good or bad month — variable costs can be adjusted on demand. For example, a warehouse often pays more for shipping during the holidays to handle increased demand.
There are several types of variable costs a business may encounter. Let’s look at some common examples:
Below are a few scenarios where variable costs may shift based on business activity:
As prices and sales volume rise and fall, it's important to understand how to calculate and forecast costs. Here’s a simple variable cost formula:
Total variable cost = variable costs per unit X number of units made
For example, an automotive parts manufacturer determines that each vehicle headlight incurs a production cost of $30. Should the firm produce 150,000 additional vehicle headlights, the variable expense would be 150,000 X $30, resulting in a total of $4.5 million in variable costs.
A variable cost analysis can help a business understand how costs fluctuate over time — which directly impacts operational efficiency and profitability. Areas where variable costs play a role include:
Whether setting prices, forecasting cash flow, or making growth decisions, understanding variable costs is critical for managing a profitable business. Discover how a PayPal business account can help your business grow.
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