Understanding and Calculating Variable Cost for Your Business: A Complete Guide
When it comes to managing a business, understanding and accurately calculating variable cost is a crucial aspect. In simple terms, variable cost refers to the costs that change with the level of production or services. It can include anything from raw materials to wages and even shipping costs. By calculating variable cost, you can effectively determine your business’s profitability and make informed decisions related to pricing and strategy. In this article, we will explore what variable cost is, how to calculate it, and its importance for your business’s success.
Understanding Variable Cost
Variable cost can be defined as the expenses that change according to a business’s production level. It is composed of all the costs that go into producing products or services, such as raw materials, labor, energy, and shipping expenses. By understanding the difference between fixed cost and variable cost, you can effectively analyze how much it costs your business to produce the goods or services it offers.
Fixed costs are expenses that do not change with production levels or increase with demand. This could be rent, equipment costs, salaries of management staff, or utilities. Variable costs, on the other hand, exist in direct relation to production and are dependent upon how many goods the business produces. For instance, more materials will be needed when producing more goods.
Another factor that distinguishes variable costs from fixed costs is that variable costs are often more challenging to predict. This makes it crucial to accurately calculate variable costs and have a deeper understanding of the factors that influence them.
How to Calculate Variable Cost for Your Business
Here is a step-by-step guide to calculate variable costs:
Step 1: Determine Direct Costs
The first step in calculating variable cost is to determine the direct costs. Direct costs are the expenses that are directly attributed to production or service delivery, such as raw materials, labor, or fuel costs. By tracking direct costs, you can estimate variable costs as an average per unit of production or delivery.
Step 2: Identify Indirect Costs
Once you have a clear understanding of direct costs, you can identify indirect costs. Indirect costs are expenses that are necessary for the business to operate but cannot be directly attributed to a specific product, service, or production line. These could include office supplies, utilities, equipment maintenance, or insurance.
Step 3: Allocate Indirect Costs
The next step is to allocate indirect costs to the production units or services offered. This can be done by using allocation methods like overhead rates, activity-based costing, or ratios. By doing this, you can determine the indirect cost per unit of production or service delivered.
Step 4: Add Direct and Indirect Costs
Once you have determined the direct and indirect costs per unit, you can add them to obtain the total cost per unit. This is your variable cost per unit of production or service delivered. By calculating variable costs, you can identify whether you are producing your goods or services at a profit or a loss.
Importance of Tracking and Analyzing Variable Cost
Tracking and analyzing variable cost is crucial for businesses as it allows them to make informed decisions related to pricing, production, and strategy. By understanding variable cost, businesses can set the right prices to ensure profitability while remaining competitive. Analyzing variable cost can also help identify areas where the business can reduce costs, increase efficiency, or optimize production. For instance, by analyzing variable costs, you may identify a cheaper supplier, optimize your employee schedule or choose a more affordable shipping option.
Beginner’s Guide to Calculating Variable Cost in a Manufacturing Business
Manufacturing businesses have a different process for calculating variable costs compared to service-based businesses. In manufacturing, variable costs are more direct and straightforward but can be challenging to calculate accurately. Here are some steps to help you calculate variable costs in a manufacturing business:
Step 1: Identify Direct Material Costs
The first cost involved in manufacturing is direct material costs. This is the cost of all the raw materials required to make the final product. Direct material costs can include anything from wood to steel to plastic. By identifying direct material costs, you can estimate the cost per unit of production.
Step 2: Calculate Direct Labor Costs
After determining direct material costs, calculate direct labor costs. This includes wages of the laborers involved in the production of the product. For instance, if workers are involved in molding plastic, extracting steel or assembling the final product, their salaries need to be considered. Direct labor costs can easily be calculated by multiplying the total hours worked by the cost per hour of labor.
Step 3: Determine Variable Manufacturing Overhead
Next up, calculate the variable manufacturing overhead. This includes all additional costs apart from direct materials and labor involved in the production of goods. This includes electricity bills, gas expenses, and maintenance costs. These are variable costs that change according to production quantity—this makes it crucial to accurately determine the overhead costs.
Using the Contribution Margin Formula to Determine Variable Cost and Profitability
The contribution margin formula is an invaluable tool when it comes to determining variable cost and profitability. Contribution margin refers to the amount of money left over after all variable costs are deducted from revenue. It can be calculated using the following formula:
Contribution Margin Ratio = (Revenue – Variable Cost) / Revenue
By using the contribution margin formula, you can identify how much of each revenue dollar goes towards covering variable costs. The contribution margin formula can help businesses make more informed decisions regarding their pricing strategy, product/service mix and expansion.
A Detailed Analysis of Variable Cost
Detailed analysis of variable costs allows businesses to identify areas of cost reduction and increase profitability. Here are some factors that affect variable cost:
Manufacturing Processes:
Streamlining the manufacturing process can help reduce variable costs. Factors that may affect this include updating and maintaining machinery, optimizing material usage and minimizing waste.
Inflation:
Inflation can cause variable costs to rise, which can affect a company’s profitability and overall success. By analyzing and anticipating any increases in variable costs, businesses can be better prepared to account for these changes in order to maintain revenue and profitability.
Quality Control:
Lack of quality control can result in variable cost increases due to producing faulty or damaged goods that need to be reworked or disposed of.
Case Study on How to Calculate Variable Cost in a Service-Based Business
In service-based businesses, calculating variable costs is essential for determining the true cost of service delivery. One way of identifying variable costs is by examining the individual service delivery process steps with the following tips:
Step 1: Determine Direct Costs:
Determine the direct costs associated with delivering each service, such as wages, fuel costs, and service delivery supplies.
Step 2: Determine Indirect Costs:
Identify the indirect costs that may be involved in the delivery of each service, such as office rent, electricity bills, and insurance.
Step 3: Allocate Indirect Costs:
Distribute indirect costs among the services offered by the business according to the level of time and effort required to deliver each service.
Step 4: Calculate Total Variable Cost:
Combine all direct and indirect costs to determine the total variable cost of delivering each service.
Comparing variable cost in Service and Manufacturing Businesses:
The primary difference between variable costs in service and manufacturing is the direct expenses involved. In a service-based business, the direct expenses may be in the form of wages or fuel costs. Meanwhile, in manufacturing, direct expenses could include raw materials, machine wear and tear, and labor.
Conclusion
As we have explored in this article, understanding and calculating variable cost is essential to running a successful business. By closely monitoring and analyzing variable cost, business owners can identify areas where they can improve efficiency, reduce costs, and increase profitability. By considering the different components of the production process and understanding the differences between direct and indirect costs, business owners can quickly determine variable costs and make informed decisions about pricing strategies and production planning.
So, whether you are running a manufacturing business or a service-based business, make sure you are regularly tracking your variable costs to ensure your business is performing at its best.
