How To Calculate Variable Cost (With Components and Examples)

By Indeed Editorial Team

Updated 7 November 2022

Published 16 August 2021

The Indeed Editorial Team comprises a diverse and talented team of writers, researchers and subject matter experts equipped with Indeed's data and insights to deliver useful tips to help guide your career journey.

Understanding the variable cost concept is crucial in determining the profit margins of a company. It helps you understand why a business that's making more profits has more production costs. Variable costs are prone to fluctuations, and that's why it's important that you understand how to calculate variable costs to help you adjust your expenses when needed. In this article, we discuss what variable costs are, how to calculate them, the components involved in variable costs and examples to help you better understand this concept.

Related: 13 Essential Accountant Skills

What are variable costs?

Variable costs are expenses that vary depending on a business's level of production. They're reliant on the volume of activity, which means that as output increases or falls, so do the costs. Common examples of variable costs include:

Related: What are variable costs? (Explanation with examples)

Direct materials

The cost of direct materials refers to the cost of raw materials used in creating a product. For a product to have direct material cost, it has to be tangible and quantifiable. Such products include steel and grains.

Direct labour

Direct labour is the cost of human resources used to produce one unit of output. This also applies when you get paid per your working hours. The more time you spend at work, the higher the pay for that day.

Shipping

Shipping costs involve the cost of transporting goods from one location to another. You can ship products either by air, water, road or rail. Additional fees can apply if the company sources some services from a third party. For example, if you're shipping a lot of goods and the shipping company can only provide two vans, you may have to pay additional fees for them to outsource another van.

Utility costs

Utility costs mean expenses for gas, water, electricity and sewage used to produce one unit of output. These can vary depending on usage, time of day, season, region and supplier rates. You may also include waste disposal as part of utility costs.

Packaging fees

Packaging fees increase as the production level increases. For example, if your company has had lots of sales recently, you might have to increase your packaging expense to cover the additional sales. Packaging materials include boxes, wrappers, bags and decorative paper.

Commissions and overtime

In most cases, companies give commissions and overtime when employees work longer than their required working hours. They also give commissions to salespeople, depending on the sales they make. Every sale contributes to a commission, meaning the more units you sell, the higher the commission.

Credit card fees

If your company accepts credit cards, they may require you to pay a certain percentage to the credit card company as a transaction fee. This may be a fixed monthly fee or a fee per transaction. You may also have to pay for other services, such as chargeback insurance.

How to calculate variable cost

Due to the fluctuating nature of variable costs, it's crucial that companies keep track of them to ensure they make the right business decisions, and to do that, they need to learn how to calculate variable cost. Staying current with potential changes in production, which can affect your variable costs, can help you save on total costs.

To calculate the total variable cost, you can use the following formula:

Total variable cost = total units produced x variable cost per unit of output

Use the following steps to apply the above formula in calculating your company's variable cost:

  1. Determine the variable costs associated with producing one unit of product in your company. Common variable costs include direct labour cost, material cost and other variable overheads.

  2. Add all the variable costs used in producing one unit to get the total variable costs per unit.

  3. Determine the total number of units produced.

  4. Multiply the total variable costs per unit by the total number of units produced.

What are the components of calculating variable cost?

To comprehend variable costs, it's important that you understand the various involved components, such as:

Variable cost per unit

Variable cost per unit is the cost of material, labour and other overheads used in producing one unit of a product in your company. For example:

If a company sells curtains at £500, with each set requiring £300 to create, package and market, the variable cost is £300 per unit.

Related: How to calculate cost per unit and why it is important

Quantity produced

Quantity produced is the total number of units of a certain item produced by your company. For instance, using the above example:

If the business made 20 curtains and sold 20 curtains, then the number of units produced is 20, each with a variable cost of £300.

Total variable cost

Total variable cost is the sum of all variable costs used in producing all the units in your company. To calculate the total variable costs, you multiply the number of units produced by the cost of producing one unit of your product:

Total variable cost = total units produced x variable cost per unit

For example:

If it costs £300 to make one curtain, then the total variable cost to make 20 units is £300 x 20, or £6,000.

Related: 14 Essential Operation Manager Skills

Average variable cost

To get the average variable cost, you divide the total variable costs by the number of units produced. Here is the formula:

Average variable cost = total variable cost / total output

Fixed costs

Fixed costs are costs that don't vary depending on the number of items you produce. Even if production stops, you still incur fixed costs. Some examples include property taxes, salaries, depreciation and rent. This is unlike variable costs, where you only incur variable costs if you're producing.

When production increases, the fixed cost per unit reduces. This is known as diminishing marginal cost. For example:

If a company is producing 10 units of curtains while in a rental building, which it pays £400 for, the fixed cost per unit is £40. However, if the business increases its production to 20 units, the fixed cost per unit reduces to £20.

Related: What are fixed vs variable costs in a business? A guide

Fixed vs. variable cost in decision-making

As a businessperson, you can use the concept of variable and fixed costs to make decisions, such as whether to close your business or not. For example:

John rents a building for one year to conduct a business, and he realises that the sales are below the total costs. He is unsure whether or not to close the company, keeping in mind that he still has to pay fixed fees such as rent and property taxes even if he closes.

In this case, you need to ascertain what comprises the costs. If the fixed costs are more than the loss you would incur per month, there is no need to close the business. For instance:

If the fixed costs are £1,000, the variable costs are £2,000 and the revenue is £2,500, then the company will be making a loss of £500 because £2,500 - £2,000 + £1,000 = -£500. This means that even if he closes the business, he still will incur £1,000, which is more than what he will lose if he continues operating the business.

Example of how to calculate variable cost

Here's an example of how you can calculate the variable costs of production:

A local shoemaker receives an order to make 50 shoes for a military camp. The shoemaker determines that the direct material cost is £50, the direct labour cost is £200 and the overhead costs are £30. To determine the variable cost of producing each shoe, the shoemaker can apply the following formula:

Total variable cost = variable cost per unit x number of units produced

Variable cost = cost of material + cost of labour + overhead costs = £280

Total variable cost = 50 x £280 = £14,000

The shoemaker's total variable cost for this order would be £14,000.

When is the concept of variable cost applied?

In business, the concept of variable costs is mostly used to determine a company's break-even point. The break-even analysis determines the number of units or the revenue a company needs to cover the total costs used in establishing the business.

The break-even formula is as follows:

Break-even point in units = fixed costs x (sale price per unit - variable cost per unit)

In addition, you can also use variable costs to determine the percentage of the fixed cost, which is essential in forecasting how the company will perform under various conditions.

Related: How to calculate marginal cost and why it's useful

Example of how to calculate the break-even point in units

Here's an example you can use to calculate the break-even point of your company:

A company wants to determine the number of units they need to produce and sell to reach their break-even point each year. The company only makes shoes, with a fixed cost of £5,000 a year, and the variable cost of producing one pair of shoes is £20 for direct labour and £50 for raw materials. In addition, the company sells each pair of shoes for £100.

You can determine the break-even point as follows:

Fixed costs = £5,000

Sale price per unit = £100

Variable cost per unit = £70

Break-even point in units = £5,000 x (£100 - £70) = 150,000 units

Therefore, to cover the total costs used in establishing the company, it would need to sell 150,000 pairs of shoes per year.

Related: How to calculate equilibrium price (with examples)

Related articles

What is average total cost formula and how to calculate it

Explore more articles