Variable Cost

A variable cost is a cost which fluctuates directly with the change in output. It changes in proportion to the change in a business activity. Variable cost is the sum of all the marginal costs over all the units produced. Variable costs are a part of total cost. All variable costs are not direct costs. Manufacturing overhead expenses that are variable are variable costs that are indirect in nature. These costs are also known as unit-level costs, as they vary with the number of units produced. Unlike fixed cost, a variable cost is difficult to budget and at times exceeds the limits of the budget. Examples of variable costs are raw materials, packaging, and labor directly involved in a company's manufacturing process.

The formula for calculating variable cost is

Total Variable Cost (TVC) = Total Quantity of Output * Variable Cost per Unit of Output

Let us take an example. If a company ABC has received an order for 5,000 widgets for a total sales price of $5,000 and wants to determine the gross profit that will be generated by completing the order. In this case we will first calculate the variable cost. The following information is provided

Annual Widgets Produced - 100,000
Raw Materials Costs - $10,000
Direct Labor Costs - $50,000

Here the cost of each widget is 10 cents ($10,000/100,000 widgets) in raw materials and 50 cents ($50,000/100,000 widgets) in direct labor costs. Using the formula we can calculate that ABC Company's total variable cost on the order is:

5,000 * ($0.10 + $0.50) = $3,000.

Hence the company can expect to earn a gross profit of $ 2000 ($5000-$3000) from the order.

Variable costs frequently appear as a factor into profit projections and the calculation of break-even points for a business or project. Here some costs may change in a piecewise manner as output changes and therefore may not remain constant per unit of output. Many cost items have both fixed and variable components. Management salaries, for example typically do not vary with the number of units produced. If the production falls dramatically or if it reaches the level zero, then layoffs may occur. This proves that all costs are variable in the long run.

Questions:

•  What is variable cost?
• How is variable cost calculated?