What's a variable cost for small businesses?
What’s a variable cost?
A variable cost is a business expense that changes according to production or sales volume. Variable costs rise when production and sales increase and fall when they decrease. Planning for these costs can be more difficult due to their fluctuating nature.
Variable costs often include expenses like raw materials, commissions, delivery costs and credit card fees. When directly related to production, these costs are called cost of goods sold (COGS).
Variable costs directly impact overall profitability - the higher the costs, the lower the net income.
Variable cost examples
What constitutes a variable cost depends on your operations, but small businesses typically have the following types of variable expenses:
production and manufacturing supplies
raw materials
sales commissions
piece labour rate
shipping and packaging costs
credit card fees
delivery fees, including gas and mileage.
What’s the difference between fixed and variable costs?
A company's variable costs vary according to its production and sales volume. These expenses fluctuate—the more you create or use, the more you pay.
Fixed costs, however, are expenses that remain the same regardless of how much a company produces or sells. Fixed expenses are stable for a set contract period, like the duration of a loan or a subscription contract, and can be short-term or long-term liabilities. They can change periodically but are usually predictable.
Budgeting for fixed costs requires caution since these expenses are paid regardless of revenue. Examples of fixed costs for small businesses include:
What is the variable cost formula?
Total variable cost
Your total variable cost is the sum of all the variable costs associated with the volume of goods or services your business produces. Use the following formula to calculate it:
Total variable cost = Variable cost per unit x Total number of units
Example: If a company spends $50 to produce a product and manufactures 100 units, the total variable cost for that product over this period is $5,000.
Average variable cost
Your average variable cost tells you how much, on average, it costs to produce a single unit. Starting with your total variable cost, use this formula to find your average variable cost:
Average variable cost = Total variable cost / Number of units produced
Example: A business that produces 1,000 units of a product with a total variable cost of $3,000 would have an average variable cost of $3 per unit.
Why do variable costs matter for small businesses?
Your variable costs directly impact how much profit and revenue you’re earning for the goods or services you offer. Tracking them is essential to maintaining profitability, especially since variable costs sometimes change unexpectedly.
Managing variable costs provides several benefits, such as:
Enhancing cash flow management
Maximising profitability through informed pricing decisions
Avoiding overspending on materials to preserve profit margins
Identifying your break-even point.
The variable cost ratio
The variable cost ratio measures an organisation's variable production costs as a percentage of its net sales. The ratio helps analyse product profitability and production costs and offers insight into future potential profits.
To calculate the variable cost ratio, divide variable costs by net sales using the following formula and express the result as a percentage.
Variable cost ratio = (Total variable costs / Total net sales) x 100
Example: If a company's total variable costs are $50,000 and total net sales are $100,000, the variable cost ratio is 0.5 (or 50% when multiplied by 100). According to this figure, the company spends 50% of its revenue on variable costs for every $1 in net sales.
How to reduce your total variable cost
1. Assess your variable costs and suppliers regularly
It’s crucial to monitor variable costs for all goods and services regularly. When costs per unit increase, you can try to renegotiate better terms with suppliers and vendors, or substitute for cheaper materials if possible.
2. Prioritise your employees
Well-trained, experienced employees will likely make fewer mistakes, waste less materials and be more efficient, helping you produce more with fewer resources. Investing in employee training and development can help your business improve its productivity and reduce costs.
Additionally, skilled employees are more likely to stay with the company longer, reducing your costs of hiring and training new employees.
3. Invest in technology
Although there are upfront costs, investments in business technology can drastically reduce variable costs.
For example, small changes like adding automatic light switches can decrease lighting-related utility usage and costs by as much as 35-45%. Workflow automation software can also make your team more effective so they can focus on mission-critical work instead of repetitive tasks.
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