Variable Cost: Definition, Formula, and Examples

A variable cost is a type of corporate expense that changes depending on how much (or how little) your company produces or sells. Depending on how your sales or production rates are going, your variable costs can rise or fall—hence the name. 

So what do you need to know about budgeting for these fluctuating costs? How do variable costs impact your bottom line? What are some examples of variable costs, and how should you consider them in your business strategy? What’s the difference between variable and fixed costs? In this guide, we’ll break down everything you need to know about variable costs.

Key Takeaways

• Variable costs are any expense that increases or decreases with your production output.
• Examples of variable costs include direct labor, direct materials, commissions, and utility costs.
• Variable costs differ from fixed costs, which don’t fluctuate depending on production output or revenue generated.
• Variable cost analysis can help you set prices, budget for future expansions, and gauge the financial success of your business.
• Accounting software can be useful for tracking and managing your variable costs.

Table of Contents

• What Is a Variable Cost?
• Variable Cost Formula
• Types of Variable Costs
• Variable Cost Examples
• Importance of Variable Cost
• What Is the Difference Between a Variable Cost and a Fixed Cost?
• Conclusion
• Frequently Asked Questions

What Is a Variable Cost?

A variable cost is a recurring cost that changes in value according to the rise and fall of a company’s revenue and output level. Variable costs are the sum of all labor and materials needed to produce units for sale or run your business. 

What does this mean for businesses? Even though the amount it costs to produce a single unit of your product is fixed, the overall cost is variable, since the total amount will change depending on how many units you’re producing. This differs from fixed costs like rent or insurance, which will remain the same regardless of your company’s activity.

Understanding your variable costs is essential for small and mid-sized businesses. The higher your variable costs, the lower your profit margin, meaning your business makes less money. Different industries tend to have more fixed or variable costs, depending on the nature of the service or product they provide. 

For instance, airlines have high fixed costs, such as paying for their aircraft. This means they have huge startup costs, but are much less vulnerable to competition once they’re up and running. 

Restaurants, on the other hand, tend to have much higher variable costs, since they depend so heavily on labor. This means that service industry businesses are more vulnerable to competition since startup costs are much lower than other types of businesses.

Variable costs have three main components that need to be considered:

Variable Cost Per Unit

Variable cost per unit refers to the total cost of producing a single unit of your business’ product. It encompasses all necessary resources, including labor, materials, marketing, and anything else needed to sell the product. Let’s say your business sells chairs for $80 each, but it costs you $25 in labor and $25 in materials to make them, for a total production cost of $50 per unit. Your variable cost per unit would be $50.

Total Variable Cost

Your total variable cost lets you calculate how much you’ve spent to create a certain number of product units. So if you’ve built 60 chairs to sell, you would multiply the variable cost per unit by the total number of units produced, like so:

$50 (cost per unit for one chair)

x 60 (total number of units produced) 

= $3,000 (total variable cost)

Average Variable Cost

Calculate your average variable cost to find out how much you spend to create a single unit of your product on average. Returning to the example of the chair company, the formula would look like this:

$3,000 (total variable cost)

/ 60 (total output of units produced) 

= $50 (average variable cost per unit)

In this example, the average variable cost formula simply works backward to arrive at our original cost per unit. 

Where average variable cost is most useful, however, is when you’re trying to calculate your average costs while accounting for multiple products with different variable costs per unit. If our chair company also produced a second type of chair that cost $40 to produce and sold for $65, you would use this formula to find your average variable cost for all types of chairs produced, not just for one or the other.

Variable Cost Formula

The formula to calculate your total variable cost is:

Total Variable Cost = Total Quantity of Output x Variable Cost Per Unit of Output

For example, the chair company gets an order for 30 chairs for a total selling price of $2,400. To find variable cost per unit, we add the cost per unit in materials ($25) and direct labor costs ($25), and multiply it by our total quantity of output (how many chairs are produced for the order).

30 x ($25 + $25) = $1,500

The total variable cost for this order of 30 chairs would be $1,500, meaning the chair company’s gross profit for the order would be $900 ($2,400 – $1,500).

Types of Variable Costs

Different industries have all kinds of different variable costs to consider. While labor and materials are the most common, you may have to account for other fluctuating expenses. Common variable costs include:

Direct Materials

Direct materials refer to any materials that are used in the production of a unit that makes it into the product itself. For example, wood is a direct material for the chair company, since the final chair is made of it. Wood is considered a variable cost because the price of it can change over time. 

An example of an indirect material would be sandpaper, which is necessary for creating the chairs, but doesn’t make it into the final product. 

Production Equipment

Production supplies and equipment refers to any necessary supplies or equipment that fluctuate with your output level. For the chair company, an example would be oil for machines involved in the woodworking process. If the company makes more chairs, they’ll need more machine oil, making this a variable cost.

Direct Labor

Direct labor is sometimes a variable cost depending on how you staff your production area. Odds are, your production area needs a minimum amount of staff to operate regardless of how many units you produce—this is a fixed cost. But if you need more staff (or need staff to work more hours) to fulfill an order, paying wages for these labor increases would be considered a variable cost.

Commissions

If your company offers commissions (a percentage of a sale’s proceeds granted to staff or the company as an incentive), these will be variable costs. This is because your commission expenses depend entirely on how many sales you make. This differs from paying an employee’s salary, which is a fixed cost. 

Transaction Fees

If your company accepts credit card payments from customers, you’ll have to pay transaction fees on each sale. This is a variable cost since it depends on how many sales you make (and what methods your customers use to pay). 

Utility Costs

The longer your production facility is actively operating, the more power and water it’s likely to use. Utilities are a variable cost because they usually increase and decrease alongside your production.

Packaging and Shipping Costs

If your company offers shipping to customers, you’ll need to consider packaging and shipping among your other variable costs. Since you’ll only need to pay for packaging and shipping if/when you make a sale for delivery, it’s considered a variable cost—even if the price of shipping remains the same over time.

Variable Cost Examples

To better explain this concept and differentiate variable and fixed costs, we’ll use a few examples to help you understand how they may apply to your industry.

Example #1

We’ll once again use the example of the chair company. As we mentioned, it costs $25 in direct labor and $25 in direct materials to produce a single chair, for a total variable cost per unit of $50. They have fixed costs of $500 for the equipment they need to produce chairs. Here’s how we’d break down variable costs for the chair company:

Chairs Produced	Direct Materials Cost	Direct Labor Costs	Total Variable Costs	Fixed Costs	Total Costs
0	$0	$0	$0	$500	$500
1	$25	$25	$50	$500	$550
5	$125	$125	$250	$500	$750
10	$250	$250	$500	$500	$1,000
25	$625	$625	$1,250	$500	$1,750
50	$1,250	$1,250	$2,500	$500	$3,000

Note how the total variable cost rises with the number of chairs produced, while the fixed cost remains the same regardless of production output. 

Example #2

Variable costs don’t just apply to manufacturing industries. They can also apply to service-based businesses. For example, a business consultant takes on a new 1-month contract. The contract will pay a total of $8,500. But to complete the contract, the consultant has to incur several variable costs, including:

• Paying for market research ($450)
• Travel out of state to work with the client ($600 for a plane ticket, $40 for cab fare)
• Renting temporary office space for one month ($800)
• Hiring a temporary assistant specifically for the contract ($25 per hour for 30 hours of work = $750)

This is a simple equation for a single contract. We would simply add up the above expenses to get the total variable cost for completing the contract:

$450 + $600 + $40 + $800 + $750 = $2,640 (total variable costs)

The consultant would then subtract the total variable cost from the project pay to get their net profit (before paying any fixed expenses):

$8,500 – $2,640 = $5,860 (profit after variable costs)

This can get more complicated if the client takes on another 1-month contract with the same client the next year, and has to incur all the same expenses again. For the sake of the example, we’ll say the consultant has $500 in monthly fixed costs (in equipment leases and a fixed-rate phone plan), whether they have a contract that month or not. Here’s how we’d break it down:

# of Contracts	Research	Travel	Temporary Office Space Rental	Labor	Fixed Costs	Total Costs
0	$0	$0	$0	$0	$500	$500
1	$450	$640	$800	$750	$500	$3,140
2	$900	$1,280	$1,600	$1,500	$1,000	$6,280

Notice how the total variable cost goes up according to the number of contracts, much like in the previous example.

Importance of Variable Cost

The data you gather from calculating your variable costs can be valuable for your business. It’s an essential tool when analyzing your expenses, setting prices, and generally gauging the profitability of your business. Here’s a breakdown of the importance of knowing your total variable cost:

Determine Pricing

One of the most common uses for variable expense info is to set prices for your products or services. 

If the chair company knows it costs $50 per unit in variable costs to produce a single chair, it wouldn’t make sense to price the chair any lower than $51, since you would lose money on each sale. You’ll also need to charge enough to cover fixed costs. 

Of course, you don’t want to charge too much and risk losing business to better-priced competition. Using the variable cost formula will help you find the sweet spot between charging too much and too little, ensuring profitability for your business.

Determine Break-Even Point

Your company’s break-even point is the number of units you need to sell in order to break even on your total expenses. Both your fixed and variable costs are essential for calculating your break-even point. It’s done like so:

Fixed Costs / (Revenue – Variable Costs) = Break-Even Point

Better Budgeting and Planning

Naturally, you’re taking steps to grow and expand your business in the future. If you’re looking to double your output next year, remember that variable costs increase as well. Calculating your variable costs from the very beginning will make it easier to create budgets and expansion plans later on.

Calculate Margins and Net Income

When you calculate your gross margin, net income, and net profit margin, you’ll need to factor your variable and fixed expenses into the formulas. Good variable expense analysis ensures you can calculate how scaling production up or down will impact the company’s bottom line. 

Choosing Expense Structure

Lastly, variable cost analysis is useful when determining your company’s expense structure. The chair company could buy an essential piece of production machinery outright for $10,000 (this would make it a fixed cost), or could choose to pay $0.10 for every unit they produce with that machine, making it a variable cost. You’ll need variable cost data to make the right decision in this scenario, which will greatly impact profitability and leverage.

What Is the Difference Between a Variable Cost and a Fixed Cost?

Understanding variable vs. fixed costs is essential for businesses looking to scale production while still remaining profitable. So what’s the difference?

Simply put, variable costs change. This refers to any expenses that fluctuate relative to the number of units the company produces, such as direct materials, direct labor, commissions, or utility costs. Fixed costs refer to expenses that do not change with production output, such as rent for your offices or salaries for permanent employees.

Conclusion

Variable costs can add a layer of unpredictability to running your business. But with a firm grasp of the variable cost formula and how to calculate variable costs for your business, you can plan ahead, keep costs under control, and ensure that you’re setting your business up for growth and success. 

If you’re looking for support with tracking all the costs that go into making your business possible, FreshBooks accounting software can help. With in-depth expense tracking, powerful reporting features, and around-the-clock support, we can support your business as it scales up and reaches new heights. Try FreshBooks free today.

FAQs About Variable Cost

Do you still have questions about variable costs and how they affect your business profitability? Read on for some frequently asked questions on the topic.

Is salary a fixed or variable cost?

Salaries are fixed costs because they don’t vary based on production or revenue. They are a regular, recurring expense and the amount paid out is set. However, if you pay commissions for every unit sold on top of a salary, they would be variable costs.

Is labor a variable cost?

Non-salaried labor can be a variable cost. If you pay based on billable hours, commissions, or piece-rate labor rates (when workers are paid based on how many units they produce), these would be considered variable costs. The same goes for staffing more hourly wage workers (or having them work more hours) to meet increased production goals.

What is an example of a variable cost per unit?

An example of a variable cost per unit would be if a company makes chairs. Each chair costs $25 in direct labor and $25 in direct materials to produce. This would mean the total variable cost per unit of a single chair would be $50.

Does variable cost increase per unit?

Yes, your total variable costs will increase as you produce more units. This is because variable costs are tied to the total quantity of units you produce. For example, if you produce 1 chair with a variable cost per unit of $50, your total variable costs would increase to $500 if you produced 10 chairs.

Is variable cost good or bad?

Variable costs are not inherently good or bad—they are a reality of providing any kind of product or service to your customers. You should strive to keep variable cost per unit as low as possible since this will result in more profit per unit. But if your total variable costs are rising, you are producing more units—hopefully at a net profit.

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