There is one frustrating truth that every business faces at the start of its growth: more money, more problems.
It seems counterintuitive – if sales and revenue are on the rise, isn’t that a good thing? Why are larger profits a potential problem?
Simply put, it all comes down to the fact that the more you sell, the more money you have to spend. This includes the marketing and sales campaigns to reach more customers, the costs of producing more products, as well as the time and money required for new product development.
Known as variable cost, this sales / expense ratio is something every business owner should understand, but online advice lists and action plans often assume that readers have an intrinsic knowledge of this concept. rather than providing a working definition.
In this article, we’ll take the confusion out of variable costs – here’s what you need to know about variable costs, how to calculate them, and why they’re important.
What is a variable cost?
Variable costs are the sum of all labor and materials required to produce one unit of your product. Your total variable cost is equal to the variable cost per unit multiplied by the number of units produced. Your average variable cost is equal to your total variable cost divided by the number of units produced.
Let’s take a look at each of these components in more detail.
Variable cost per unit
Variable cost per unit is the amount of labor, materials, and other resources needed to make your product. For example, if your business sells kitchen knife sets for $ 300, but each set requires $ 200 to create, test, package, and market, your variable cost per unit is $ 200.
Number of units produced
The number of units produced is exactly what you might expect – the total number of items produced by your business. So, in our knife example above, if you made and sold 100 sets of knives, your total number of units produced is 100, each with a variable cost of $ 200 and a potential profit of $ 100.
Variable cost formula
To calculate variable costs, multiply the cost of manufacturing one unit of your product by the total number of products you created. This formula looks like this: Total variable costs = cost per unit x total number of units.
Variable costs deserve the name because they can go up and down as you manufacture more or less of your product. The more units you sell the more money you will earn, but some of that money will have to pay for producing more units. You will therefore have to produce After units to make a profit.
And, because each unit requires a certain amount of resources, a higher number of units will increase the variable costs required to produce them.
Variable costs are not a “problem”, however, they are more of a necessary evil. They play a role in several bookkeeping tasks, and your total variable cost and average variable costs are calculated separately.
Total variable cost
Your total variable cost is the sum of all the variable costs associated with each individual product that you have developed. Calculate the total variable cost by multiplying the cost of manufacturing one unit of your product by the number of products you have developed.
For example, if it costs $ 60 to make one unit of your product and you made 20 units of it, your total variable cost is $ 60 x 20, or $ 1,200.
Average variable cost
Your average variable cost uses your total variable cost to determine how much, on average, it costs to produce one unit of your product. You can calculate it with the formula below.
Total variable cost versus average variable cost
If the average variable cost of a unit is calculated using your total variable cost, don’t you already know how much a unit of your product to develop costs? Can’t you work backwards and just divide your total variable cost by the number of units you have? Not necessarily.
While the total variable cost indicates how much you pay to develop each unit of your product, you may also need to consider products that have different variable costs per unit. This is where the average variable cost comes in.
For example, if you have 10 units of Product A at a variable cost of $ 60 / unit and 15 units of Product B at a variable cost of $ 30 / unit, you have two different variable costs – $ 60 and $ 30. Your average variable cost reduces these two variable costs to a manageable number.
In the example above, you can find your average variable cost by adding the total variable cost of product A ($ 60 x 10 units, or $ 600) and the total variable cost of product B ($ 30 x 15 units, or $ 450), then dividing this sum by the total number of units produced (10 + 15, or 25).
Your average variable cost is ($ 600 + $ 450) ÷ 25, or $ 42 per unit.
Variable cost vs fixed cost
The opposite of variable cost? Fixed costs. Fixed costs are costs that do not change based on the number of products you produce.
Some common fixed costs include renting or leasing a building, utility bills, website hosting, business loan repayments, and property taxes.
To note? These charges are not static – which means that your rent may go up from year to year. Instead, they remain fixed only with reference to the production of products.
To calculate the average fixed cost, use this formula:
Variable and fixed costs are key to getting a complete picture of how much it costs to produce an item – and how much profit is left after each sale.
What is the variable cost ratio?
The variable cost ratio allows companies to identify the relationship between variable costs and net sales. Calculating this ratio helps them account for both increased revenue and increased production costs, so that the business can continue to grow at a steady pace.
To calculate the variable cost ratio, use this formula:
Let’s put it into practice. If you sell an item for $ 200 (net sales) but it costs $ 20 to produce (variable costs), you divide $ 20 by $ 200 to get 0.1. Multiply by 100 and your variable cost ratio is 10%. This means that for every sale of an item, you get a 90% return on your investment, of which 10% is spent on variable costs.
The combination of variable and fixed costs, on the other hand, can help you calculate your break even – the point at which the production and sale of goods is canceled out by the combination of variable and fixed costs.
Consider our example above again. If your variable costs are $ 20 on a $ 200 item and your fixed costs are $ 100, your total costs are now 60% of the item’s sale value, leaving you with 40%.
Simply put? The higher your total cost ratio, the lower your potential profit. If that number turns negative, you’ve crossed the break-even point and will start losing money with every sale.
So what is considered a variable cost to the business?
Some of the more common variable costs include physical materials, production equipment, sales commissions, staff salaries, credit card fees, online payment partners, and packaging / shipping costs. shipping.
Examples of variable costs
- Physical materials
- Production equipment
- Sales commissions
- Staff salaries
- Credit card charges
- Online payment partners
- Packing and shipping costs
Let’s look at each in more detail.
These can include parts, clothing, and even food ingredients needed to make your final product.
If you automate parts of your product development, you may need to invest in more automation equipment or software as your product line grows.
The more products your business sells, the more commission you could pay your salespeople as they earn customers.
The more products you create, the more employees you will need, which also means more payroll.
Credit card charges
Businesses that receive credit card payments from their customers will incur higher transaction fees as they provide more services.
Online payment partners
Apps like PayPal typically charge businesses per transaction so that customers can verify their purchases through the app. The more orders you receive, the more you will pay in the app.
Packing and shipping costs
You may pay to package and ship your product individually, so more or less units shipped will vary these costs.
Expect the unexpected
While variable costs, total variable costs, average variable costs, and variable cost ratio often seem complicated at first glance, these terms are simply ways of representing the changing nature of costs to produce new items as your business develops. business is growing.
By understanding the nature of these costs and their impact on your current and projected revenues, it is possible to better prepare for changing market forces and reduce the impact of variable costs on your bottom line.