The Definition of and Formula for Variable Cost

Money

Variable cost is something that comes up a lot in economics and its related fields. In short, variable costs are costs that change based on the number of products and services that businesses produce. For example, suppose that a business makes boxes. Both the materials and the labor used to make the boxes would be considered variable costs because they rise and fall based on the number of boxes that are produced. In contrast, the cost of rent for the building that houses the production facilities would be considered a fixed cost because it is not affected by the number of boxes that are produced. On top of this, it is important to note that some variable costs are direct variable costs, whereas other variable costs are indirect variable costs.

How Can Variable Cost Be Calculated?

Generally speaking, calculating variable cost is a simple and straightforward process. For example, one potential solution would be figuring out the variable costs that are applicable for the business’s products and services. After which, calculating said figure should be as simple as adding them up. However, it is also possible to get the variable cost by deducting the fixed cost from the total cost, which can prove to be even easier under certain circumstances.

With that said, variable cost isn’t that useful. It tells people how much the business has spent on costs that changed based on the number of products and services produced, but it tells people very little beyond that. As a result, variable cost isn’t that helpful when it comes to guiding decision-making, which is why there are a number of calculations that can be done to produce further insight into the business’s financial circumstances.

For example, one of the most common calculations would be dividing variable cost by the number of products and services that have been produced to come up with the variable cost per unit. Theoretically, this would be the cost that a business would incur by increasing its production by one unit as well as the cost that the same business would prevent by decreasing its production by one unit, thus making it very useful for people who are attempting to figure out whether their production numbers are set the most profitable level for them. However, it should be mentioned that each additional unit of production doesn’t necessarily incur the same change in variable cost as its predecessors. As a result, while the variable cost per unit is very useful, interested individuals should not put more faith into it than what it warrants.

Of course, variable cost per unit is far from being the sole figure that can be calculated by using variable cost. Another example would be the variable cost ratio, which would be the variable cost divided by total revenues. The product of this calculation has a wide range of uses for both managers and external stakeholders. For example, it can be used to help the business set the optimal price as well as the optimal production for its products and services. Likewise, it can be used to help interested parties get a rough estimate of the business’s future performance based on incomplete information, particularly when used with other figures based on historical data. Summed up, the variable cost ratio is very versatile, which is why interested parties would do well to familiarize themselves with its uses.

It’s a Useful Tool

Ultimately, variable cost is a useful tool for various parties to get a better understanding of a business’s financial circumstances. However, it is important to remember that it is either an imperfect or an incomplete representation of the truth of things, meaning that interested parties shouldn’t become too focused upon it to the exclusion of other information. For example, if a business sees that its variable cost is too high, it might seek to increase its profitability by lowering its variable cost. Unfortunately, if the business is not careful about which variable costs it cuts as well as how they are cut, it could have a negative impact on its sales, thus defeating the whole point of the initiative in the first place. Simply put, everything about a business is inter-connected, meaning that interested individuals should never fail to consider how each part might affect the rest.



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