What it means
If you make twice as many products, your variable costs roughly double, and if you make none they fall to zero. This is the key difference from fixed costs such as rent or salaried staff, which stay broadly the same across a normal range of activity.
Common variable costs include direct materials, hourly production labour, packaging, payment processing fees, delivery and sales commissions. Per unit, the cost stays about constant, but in total it moves with volume.
Variable cost matters most in decisions about extra volume. The price of an additional unit must at least cover its variable cost, otherwise each sale makes the loss bigger, and the amount left over after covering variable cost is called the contribution margin.
Many costs are mixed, with a fixed element and a variable element. A mobile phone contract with a monthly line charge plus a charge per gigabyte is a simple example, and analysts often split such costs into the two parts to forecast them properly.
There is a nuance over time. Costs that look fixed over a month, such as machine capacity, can become variable over several years as the business adds shifts, machines or sites, and bulk discounts can make per-unit variable cost fall as volume rises.
Managers also use variable cost to set a floor for discounting. Any price below the variable cost per unit loses money on every sale, while a price above it contributes something towards fixed costs, so the variable cost figure tells a salesperson how far a negotiation can safely go.
In practice
Real-world examples
Example 1
A coffee shop buys beans, milk and cups for every drink it sells. These costs total about $1.10 per drink, so selling 1,000 more drinks adds around $1,100 of variable cost. The owner uses the figure to decide whether a $2.50 promotional drink still makes money.
Example 2
A software company pays a payment processor 2.9% of every subscription charged. On $200,000 of monthly sales, processing fees are 200,000 x 2.9% = $5,800. If sales double to $400,000 the fees double to $11,600.
Example 3
A furniture maker pays carpenters per piece finished. Because pay moves with output, a slow month produces a small wage bill and a busy month a larger one. The owner treats the labour as variable when building the budget.
Think of it
Think of variable costs like ingredients for a recipe. If you are cooking dinner for two people, you only need a small amount of food. If you suddenly host a dinner party for twenty people, your grocery bill goes up because you need ten times as many ingredients. If no one comes over, you spend nothing on food.
Formula
Calculation
Total variable cost = Variable cost per unit x Number of units
Contribution margin per unit = Selling price per unit - Variable cost per unit
A company makes phone cases. Each case costs $3.50 in materials, $1.50 in labour, $0.50 in packaging and $0.50 in shipping, so the variable cost per unit = 3.50 + 1.50 + 0.50 + 0.50 = $6.00. At 20,000 cases, total variable cost = 6 x 20,000 = $120,000. The selling price is $15, so revenue = 15 x 20,000 = $300,000 and total contribution = 300,000 - 120,000 = $180,000. With fixed costs of $100,000, profit = 180,000 - 100,000 = $80,000. At 25,000 cases, total variable cost rises to 6 x 25,000 = $150,000 while the per-unit figure stays at $6.Case study
Seen in the real world
Northfield Candles is an illustrative, fictional business that sells scented candles online. A retailer asked for a one-off order of 5,000 candles at $7 each, which was well below the usual price of $12.
The owner was tempted to refuse, but her accountant split the costs. Variable cost per candle was $5.20 for wax, glass, fragrance, labour and shipping, so each candle in the order left a contribution of 7 - 5.20 = $1.80, and the order as a whole contributed 5,000 x 1.80 = $9,000.
Because the factory had spare capacity and fixed costs would not change, the order added $9,000 to profit. In the illustrative sequel, the owner accepted it, while setting rules to stop the lower price from spreading to regular customers.
Watch out
Common mistakes
- Treating variable cost per unit as if it fell with volume, when per-unit cost stays roughly the same and it is the total that rises.
- Pricing a product below its variable cost, which increases the loss on every unit sold.
- Classing a cost as fixed or variable by its label alone, when many costs are mixed and need to be split.
Questions
People also ask
Is direct labour always a variable cost?
Not always, because salaried workers on fixed contracts are a fixed cost in the short term, while workers paid per hour or per piece are variable.
What is the link between variable cost and contribution margin?
Contribution margin is the selling price less variable cost, and it is the amount each sale adds towards covering fixed costs and profit.
Can a variable cost become fixed?
Yes, if a business agrees a minimum purchase commitment or a flat fee, a cost that was variable can behave as fixed up to a limit.