How To Calculate Variable Cost in 3 Steps (With Examples)

By Indeed Editorial Team

Updated 6 September 2022 | Published 30 August 2021

Updated 6 September 2022

Published 30 August 2021

The Indeed Editorial Team comprises a diverse and talented team of writers, researchers and subject matter experts equipped with Indeed's data and insights to deliver useful tips to help guide your career journey.

Variable costs are production expenses, like labour and supplies, which fluctuate based on a business's production levels. As a company manufactures more products, it needs more resources, so its variable costs increase. By understanding this metric, businesses can determine their potential profit margins and the feasibility of their operations. In this article, we discuss what variable cost is, how to calculate it and how it differs from fixed cost.

What Are Variable Costs?

Variable costs are expenses that change depending on a company's level of production. Level of production is the number of products a company is manufacturing at a given time. As output rises and falls, variable costs follow in a direct relationship. This is because if a company wants to make more products, they need more resources and labour to do so. Common examples of variable costs include packaging, manual labour and raw material production. Other examples include:

  • Direct materials cost: This type of cost refers to any raw materials necessary to create a product, specifically those that are identifiable, quantifiable and tangible. Examples include grains, meat, steel and wood.

  • Shipping: This type of cost refers to expenses involved in the transportation of goods from one place to another, and may include vehicles and gas. Businesses pay for the shipment of products by air, road, water and railroad.

  • Commissions: Employers may need to pay commissions when they require their employees to work long hours. As employers usually work longer hours to increase production levels, commissions are a type of variable cost.

  • Piece rate labour: Some employees work on a piece rate, meaning they receive payment for every unit of work or product they deliver, often in circumstances where quality significantly outweighs quantity. This type of salary is a variable cost because it depends on employee performance and production level.

  • Supplies and packaging: The demand for supplies and packaging materials fluctuates with production levels, as companies use a certain amount of packaging for each product. Packaging materials can include decorative paper, bags, boxes, ties and wrappers.

Related: What Is Quality Control? A Complete Guide

How To Calculate Variable Cost

Calculating variable cost is one way to assess production expenses. Here are three steps for how to calculate variable cost per unit:

1. Find the per-unit cost of output

A per-unit cost includes the expense required to produce, store and ship a single unit of a product. These costs can include material, overhead and labour. A company's unit cost is important in understanding how well its overall operations perform. It also helps determine if a company can produce an item more efficiently.

2. Find the total quantity of units of output

Determine how many units of product or output the company is producing at a given time. This figure is important, as it directly affects the variable cost. As manufacturing requires resources, the more you produce, the more expensive your production costs.

3. Use the variable cost formula

Write the industry standard formula for calculating variable cost so you can fill in the correct values. Here is the formula:

Total variable cost = Cost per unit of output x Total quantity of units of output

Fill in the values and calculate to find total variable cost.

Why Is It Useful To Know How To Perform This Calculation?

It is useful to know how to calculate variable cost because this can help people plan their business. They can check their cost per unit to see whether they can afford their production materials or need to change their methods. They can also check if their net sales outweigh their total variable costs to see if they are profitable and can remain operational. Calculating variable cost is often the task of an accountant. However, whether you are in a leadership position or just an entry-level employee, understanding variable cost and profitability can help you appreciate your duties in a company.

Related: Basics of Accounting - Terminology, Principles and Concepts

Variable Cost Calculation Examples

Review these examples to help you with your own calculation of variable cost:

Example 1

A local baker recently received an order to bake 200 cupcakes for a wedding. The bride wants all vegan ingredients in her cupcakes. Orders like this are rare for the baker, so he has to purchase the necessary ingredients. The baker determines that a single cupcake will cost him $1.50 to produce. Here is his calculation for total variable cost:

Total variable cost = Cost per unit of output x Total quantity of units of output

Total variable cost = $1.50 x 200

Total variable cost = $300

In this example, the baker determined that his total variable cost for this order would be $300. This can help him determine the pricing for his products.

Example 2

A large cosmetics distribution company prepares for their largest shipment yet. They have 2,000,000 units of products in their warehouse. When determining costs, executives have to account for the cost of ingredients, packaging and clear wrap. The list of accumulated costs are:

  • Ingredients per unit: $12

  • Packaging per unit: $8

  • Clear wrap per unit: $2

In total, the cost per unit amounts to $22. The cosmetics company can now place that amount into the formula:

Total variable cost = Cost per unit of output x Total quantity of units of output

Total variable cost = $22 x 2,000,000

Total variable cost = $44,000,000

The total cost to create and store each unit amounts to $44,000,000. This seems like an extraordinary number, but if each unit sells for a luxury price point of $52, the company can earn $104,000,000. This means a $60,000,000 profit. The company can only calculate this data because they used the variable cost formula. They can use this profit margin to adjust their per-unit costs for future shipments.

What Are Fixed Costs?

Fixed costs are those that are typically constant. As opposites of variable costs, fixed costs do not depend on production levels. This means a business has to pay fixed costs no matter what its production level is. Here are some examples of fixed costs:

  • Rental lease or mortgage payments: Businesses lease or buy space for their operations, and pay rent or mortgage payments on it over time. These payments can vary greatly depending on the contract and location, but they are often monthly.

  • Some utilities: Some utilities may also cost the same each month and count as fixed costs. These utilities may be electricity, gas, phone lines, internet networks, trash removal services and sewer services.

  • Real estate taxes: Real estate taxes are payments that businesses give to local and national governments to help fund social services. Typically, businesses can rely on these taxes and others to remain the same or similar each year.

  • Employee payroll: Unless it is a piece-rate labour system, employers typically pay their employees a fixed salary, no matter how many products they manufacture. This dependable salary is necessary to attract and maintain talented team members.

  • Insurance coverage: Along with monetary compensation, many businesses offer their employees benefits packages, such as health, vision and dental insurance. Businesses pay a fixed amount for these insurance policies each month.

  • Loan payments: Many business owners take out a loan to have enough capital to start and operate their business. As loan payments are regular and due regardless of production level, they are a type of fixed cost.

Related: Gross Salary and Net Salary: Definitions and Examples

How To Calculate Fixed Cost

Here are three steps for how to calculate the average fixed cost per unit:

1. Find the total fixed cost

Fixed costs are all expenses that do not depend on levels of production, but are still necessary for production and the operation of a business. These could be utilities, rent payments or other regular payments related to the business. Find the various fixed costs and add them together to get the total fixed costs.

2. Find the total quantity of units

Just as in the calculation of variable cost, figure out how many units of a product you are producing at a given time. You could use a time period of a month, quarter or year, for example. While the number of units of a product may change over time, it does not directly affect the fixed costs.

3. Use the formula

Formulas are templates for calculations. Here is the formula for average fixed cost:

Average fixed cost = Total fixed cost / Total quantity of units of output produced

Fill in the values and calculate to find the average fixed cost.

Differences Between Variable Costs And Fixed Costs

Both variable and fixed costs make up total expenses. Fixed costs do not change in tandem with production. Even if production halts, fixed costs continue. Alternatively, variable costs change with the flow of production. If production halts, there are no variable costs.

When production increases, fixed costs reduce per-unit costs. People in business refer to this as diminishing marginal cost. However, companies that have significant variable costs deliver more predictable per-unit profit margins. For example, if sales decrease with high fixed costs, profit margins narrow significantly. If sales increase instead, profits can multiply.


Related:

  • What Is Cost Accounting? (Definition And Objectives)

  • What Is Risk Management? (Crucial Steps And Strategies)

  • What Is Fixed Cost Formula? (Definition and Examples)

  • What Is A Contingency Plan? (Importance And Example)

  • What Is A Break-Even Point? Examples And How To Calculate It

  • What Is Cost Unit? (Definition, Calculation and Examples)

  • What Is Variable Pay and Why Do Employers Offer It?


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