On the income statement, which of the following would be classified as a variable cost?
A) Promotion Expense
B) Depreciation Expense
C) R&D Expense
D) Direct Labor Expense
In an income statement, Direct Labor Expense can be classified as Variable Cost because these are the costs that do fluctuate directly with the volume of production output. Variable costs are usually viewed as short-term costs as they can be adjusted quickly. A variable cost is an expense that changes in proportion to production output or sales. When production or sales increase, variable costs increase; when production or sales decrease, variable costs decrease.
Variable costs are the sum of marginal costs over all units produced. They can also be considered normal costs. Fixed costs and variable costs make up the two components of total cost. The level of variable cost is influenced by many factors, such as fixed cost, duration of project, uncertainty and discount rate. Variable costs are sometimes called unit-level costs as they vary with the number of units produced.
Variables cost are those costs which tend to vary in direct proportion and same direction to changes in production activity, sales activity or some other measures of volume or cost driver. The cost of these inputs increases/decreases as volume or cost drivers increase/decrease.Variable costs change in a direct proportion to and in the same direction as the changes in activity levels or outputs. The variable expenses are activity-based since they are incurred as a direct result of output, work or activity. If the output doubles, variable costs will also double and vice versa. Some common examples of variable costs include, costs of good sold (COGS), raw materials and inputs to production, packaging, wages, and commissions, and certain utilities.
The characteristics shown by variable costs are as follows:
- The per unit cost of variable cost is fixed.
- Total variable costs are proportionately related to operate activity levels.
- Cost variables can be regulated and controlled within the same responsibility center and within the short-term as well.
- Variable costs are those that change proportionately in total but remain constant per unit.
Variable Cost Formula
|Total Variable Cost = Total Quantity of Output x Variable Cost Per Unit of Output|
Common Variable Costs
Some of the common variable costs are as follows:
Direct Materials: Direct material costs are the costs associated with raw materials and components used in the creation of a product. The materials must be easily identifiable with the final product (otherwise, they are considered joint costs). Among the few variables involved in the production process, direct material cost is used to calculate throughput.
Direct Labor: Direct labor costs are wages incurred during the process of manufacturing goods or providing services. Direct labor cost is significantly more than wages paid. In addition, it includes any payroll taxes associated with those wages, as well as company-paid medical insurance, life insurance, workers’ compensation insurance, matched pension contributions and other employee benefits.
Transaction fees: A transaction fee is a fee a business pays every time it processes a customer’s payment. Prices of transaction fees vary depending on the service that is used. This is an additional payment for the merchant’s already successful purchases.
Commissions: Business companies pay commissions to salespeople for their services in facilitating, supervising, or completing sales. A commission may be paid as a flat fee, or (more commonly) as a percentage of the revenue generated. A salesperson is paid a commission only if they sell products or services, so this is a variable cost.
Utility Costs: Utilities costs refer to the cost incurred by using utilities such as electricity, water, waste disposal, heating, and sewage. The expenses of utilities are incurred over the course of the reporting period, calculated, and accrued for, or payment is rendered. This cost varies with its expenses, that’s why it is treated as variable cost.
Example of Variable Costs
Assume a business produces clothing. A variable cost of this product would be the direct material, i.e., cloth, and the direct labor. If the business uses a room, a sewing machine, and 8 hours of a laborer’s time with 6 yards of cloth to make a shirt, then the cost of labor and cloth increases if two shirts are produced, and those are the variable costs. The facility and equipment are fixed costs, incurred regardless of whether even one shirt is made.
|0 shirts||1 shirt||2 shirts||3 shirts|
|Cloth (Direct Materials)||0yds||6yds||12yds||18yds|
|Labor (Direct Labor)||0hrs||8hrs||16hrs||24hrs|
|Equipment||1 machine||1 machine||1 machine||1 machine|
|Facility (overhead)||1 room||1 room||1 room||1 room|
The amount of materials and labor that goes into each shirt increases with the number of shirts produced. In this sense, the cost “varies” as production varies. In the long run, if the business planned to make 0 shirts, it would choose to have 0 machines and 0 rooms, but in the short run, even if it produces no shirts it has incurred those costs. Similarly, even if the total cost of producing 1 shirt is greater than the revenue from selling the shirt, the business would product the shirt anyway if the revenue were greater than the variable cost.
If the revenue that they are receiving is greater than their variable cost but less than their total cost, they will continue to operate will accruing an economic loss. If their total cost is less than their variable cost in the short run, the business should shut down. If revenue is greater than their total cost, this firm will have positive economic profit (Wikipedia, n.d.).
Short Numerical Question on Variable Costs
A Company produces a ceramic coffee mugs for a cost of $5 per mug. If the company produces 800 units, what will be its variable cost?
- Variable cost per unit = $ 5 per mug
- Total Quantity of Output = 800 units
Total Variable Cost = Total Quantity of Output * Variable Cost Per Unit of Output = 800* $5 per mug = $ 4000
Therefore, the variable cost will be $4000.
Difference between Fixed Cost and Variable Cost
|Fixed Cost||Variable Cost|
|The costs which largely remain constant, is known as fixed cost.||The costs that vary with services or are unpredictable, is known as fixed cost.|
|Fixed costs are usually independent to a company’s specific business activities||When variable costs increase the production rises and when it decreases the production falls.|
|Company cannot avoid fixed cost.||Company can avoid cost.|
|This cost is predictable and fixed in nature.||This cost is unpredictable in nature.|
|Some of the examples of fixed costs are; Rent, Car payment, property taxes, insurance premium, etc.||Some of the examples of variable costs are; Utilities, personal cost, factory overhead, etc.|
Importance of Determining Variable Cost
Some of the most important reasons for a company to determine variable cost:
To Make informed business decisions: In order to plan strategically, a company considers variable cost as a key performance metric. If a company has a high proportion of variable costs, it may still be able to operate even if its sales volume is relatively low. In similar way, a high proportion of fixed costs often means that the business will have to maintain a high volume of sales in order to remain financially viable.
Monitor variable costs: Though fixed costs associated with running a business remain relatively constant irrespective of output, variable costs will always add to the total variable cost as production increases.
Decide on an appropriate sales target: Expenses associated with variable costs should not be viewed as a negative indicator. To reach sales targets, it is always necessary to ramp up production, which can add to costs. Variable costs usually increase when a company strives to achieve higher revenue goals.
Prevent overspending on materials or underpricing the unit cost: It is essential to ensure that revenue increases faster than expenses. An example is if a company reports an increase in volume of 8%, but sales only increase by 5% over the same period, then each product will likely be underpriced.
Manufacturing Costs Reduction: It is generally beneficial for businesses to lower their costs of manufacturing their products in order to remain profitable. Thus, managers monitor profitability by dividing the variable costs by the total revenue in order to calculate the cost as a percentage of sales.
Identify break-even point: For projects or ventures, companies often consider variable costs when they make profit projections and calculate break-even points. There may be fluctuations in expenses based on a change in output, which may result in inconsistencies on your balance sheet. It might be necessary to adjust your selling price per unit to maintain your profit margin based on these types of changes.
Analysis of fixed costs for reducing unnecessary expenses: It is also worth mentioning that many products have variable and fixed components. The salaries of management, for example, are usually unrelated to the number of units produced. In spite of this, companies may implement layoffs even at the executive level if production declines. It is possible to argue that all costs are, at some level, variable.
Ways to reduce Variable Costs in Business
As variable costs are controllable in nature, we can reduce it for the welfare and profit maximization of the business. Some of the ways to reduce variable costs in business are as follows:
- Negotiating with the providers for the discounts by volume of purchase.
- Working for the improvement of production process and sales process.
- Analyzing variable expenses and reducing the unwanted expenses from the business activities.
- Implementing business with technology will also help to reduce variable cost in the business.
- Outsourcing the labor force a certain task can help to reduce labor overhead.
- Application of the principles of lean management in the business activities.
The other types of Variable Cost include:
- Direct Materials Cost
- Variable Overhead
To determine whether or not variable costs are staying constant, divide total variable cost by revenue. This will give you an idea of how much of costs are variable costs. You can then compare this figure to historical variable cost data to track variable cost per units increases or decreases. Sometimes there occurs confusion whether Salaries and Wages are variable cost or Fixed cost. In this case, Wages that is paid to workers for their regular hours considered as fixed cost where if they spend Any extra time on the job then it is regarded as variable cost.
Variable Costing is that method of inventory costing in which all variable manufacturing costs are included as inventoriable costs. All fixed manufacturing costs are excluded as inventoriable costs. They are instead treated as costs of period in which they are incurred. Variable costing is more accurately perceived as direct costing or marginal costing as it applies only the variable production cost to the product.
Some FAQs related to Variable Costs
Is marginal cost the same as variable cost?
Answer: Marginal cost refers to the business expense which is associated with the production of an additional unit of output or by serving an additional customer. A marginal cost is the same as an incremental cost, as it increases incrementally as the product is produced. Variable costs can be included in marginal costs because they are associated with production and expense. Variable costs vary with production levels, so marginal costs will also be included in total production costs.
Are there ways to reduce a business variable cost?
Answer: Businesses can reduce their variable costs in a variety of ways. As an example, using more material with the same output can dramatically reduce costs, provided the quality of goods doesn’t suffer. By adopting new or improved technological processes or machinery, companies can reduce variable costs. In the event this isn’t possible, management may be able to spot opportunities for efficiencies and improvements, which can bring down certain variable costs like utilities and labor.
Is inventory carry expense a variable cost ?
Inventory carry expense is a common variable cost for businesses. This is because the amount of inventory that a business has on hand can change over time, which means that the company needs to spend money to keep the inventory updated.
Is research and development expense a variable cost?
Research and development expense is often viewed as a fixed cost, since the amount of money that is spent on R&D will not change with changes in demand or other factors. However, recent research has shown that R&D expense can be a variable cost. This means that the amount of money that is spent on R&D will vary depending on the market conditions and other factors.
Variable cost is a key factor in determining a business’ breakeven point. If variable costs decrease, then the breakeven point moves lower, representing a greater profit potential for the business. In order to understand how variable costs affect the breakeven point, it is important to understand how these costs are determined.
The slope of the total variable cost curve equals the average total cost. This means that as the amount of output produced increases, the average total cost also increases.
In business, one of the key determinants of success is the rate of change in variable cost. This rate can be impacted by a variety of factors including market conditions, production levels and technological advances. In order to stay ahead of the competition, businesses need to be able to constantly adjust their production levels in order to keep costs down. By understanding how variable cost changes over time, businesses can make more informed decisions about their overall operations.
Variable Cost Quiz / MCQs
RST Company produces a product that has a variable cost of $6 per unit. The company’s fixed costs are $30,000. The product sells for $10 per unit. RST desires to earn a target income of $20,000. The sales level in dollars to achieve the desired target income is $ .
Variable cost per unit, within the relevant range, will ________.
A) increase as production decreases
B) decrease as production decreases
C) remain the same as production levels change
D) decrease as production increases
Which of the following describes the behavior of a variable cost per unit?
a) varies in decreasing proportion with changes in the activity level.
b) varies in increasing proportion with changes in the activity level.
c) varies in direct proportion with the activity level.
d) remains constant with changes in the activity level.
If you operated a small bakery, which of the following would be a variable cost in the short run?
A) Baking ovens.
B) Interest on business loans.
C) Annual lease payment for use of the building.
D) Baking supplies (flour,salt,etc. ).
A cost that has characteristics of both a variable cost and a fixed cost is called a
a) discretionary cost.
b) variable/fixed cost.
c) mixed cost.
d) sunk cost.
A cost that includes both fixed and variable cost components is called a:
a) Mixed cost.
b) Step-variable cost.
c) Composite cost.
d) Curvilinear cost.
e) Differential cost.
If price exceeds average variable cost but is less than average total cost, a firm
a) Making a profit and should continue to produce
b) Incurring a loss but should continue to produce
c) Incurring a loss and should stop producing immediately
d) Break even and maintain current output
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Corporate Finance Institute. (n.d.). Retrieved from Corporate Finance Institute: https://corporatefinanceinstitute.com/resources/knowledge/accounting/variable-costs/
Fsalvador. (2021, December 21). Camino Financial. Retrieved from Camino Financial: https://www.caminofinancial.com/how-to-reduce-your-business-variable-expenses/
Kenton, W. (2021, August 29). Investopedia. Retrieved from Investopedia: https://www.investopedia.com/terms/v/variablecost.asp
Millelo, L. (2021, May 5). Bankrate. Retrieved from Bankrate: https://www.bankrate.com/banking/fixed-expenses-vs-variable-expenses/#:~:text=Fixed%20expenses%3A%20These%20are%20costs,dining%20out%20or%20car%20repairs.
Nickolos, S. (2021, March 13). Investopedia. Retrieved from Investopedia: https://www.investopedia.com/ask/answers/032515/what-difference-between-variable-cost-and-fixed-cost-economics.asp
Wikipedia. (n.d.). Retrieved from Wikipedia: https://en.wikipedia.org/wiki/Variable_cost
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