Understanding variable costs for businesses

Small business owners should understand variable costs so they can optimize their budgets and position their companies for growth.

What is a variable cost?

First, it’s important to answer the question: What is a variable cost? In a business context, a variable cost is an expense that varies depending on production or sales levels. Unlike fixed costs, which remain the same regardless of output, variable costs may change based on business activity.

Variable costs are pivotal in determining your gross profit margin, a key indicator of business financial health. Below are some factors associated with variable costs:

Dependence on business production levels

Production levels refer to the quantity and output of products and services. Business production levels can change based on customer demand, seasonality, and budget.

Take a restaurant, for example. During a busy holiday season, it may need to accommodate an influx of customers. To meet this demand, the business may need to hire more waiters and cooks, and purchase more food from its suppliers. These are all variable costs, which increase based on increased levels of business production.

Pricing, cost of goods sold, and profit margins

Variable costs can be used to determine pricing strategies and the cost of goods sold (COGS). To cover increased variable costs, for instance, a business might increase the price of a popular product. This way, the business can adjust its profit margin and still meet its bottom line.

Consider a small clothing retailer, for example. The business owner just found out that their manufacturer is increasing production costs. As a result, the retailer’s expenses are going to go up and its profit margins are going to go down. To cover this variable cost, the retailer increases the price of its clothes — at least until it can negotiate a lower rate with its manufacturer or find another production partner.

Control and flexibility

Unlike fixed costs — such as rent, utility bills, and other recurring payments that remain the same whether a business has a good or bad month — variable costs can be adjusted on demand. For example, a warehouse often pays more for shipping during the holidays to handle increased demand.

Examples of variable costs in business

There are many examples of variable costs a business may encounter — from labor costs to payments processing fees.

Common variable costs include:

• Raw materials. These materials are used to directly manufacture a product. A company typically spends more on raw materials as production increases.

• Direct labor. These costs can change based on increased demand or production levels, such as overtime for factory workers.

• Energy and utilities. Also used in the production process, the cost of utilities, such as electricity and water, may increase with production.

• Freight and shipping. The cost to get goods to customers will rise and fall, often seasonally, or as a result of supply chain disruptions.

• Sales commission. As sales increase, commissions to sales teams will usually rise.

• Payment processing fees. Whether in a physical or online shop, credit card processing fees fluctuate with the volume of transactions.

• Marketing campaign. The cost of pay-per-click ads or influencer marketing campaigns paid on commission, for example, can change based on campaign engagement.

Variable costs based on business activities

Below are a few scenarios where variable costs may shift based on business activity:

• Increased sales commissions. If a business employs many sales representatives, commission payments may soar during periods of increased sales.

• Boosts in production. For a manufacturing company, an uptick in production can lead to more hours of operation, resulting in greater utility and labor costs.

• Business trips. A consulting firm may incur travel costs, such as hotel bills and air fare, when visiting clients for business trips.

How are variable costs different from fixed costs?

True to their names, variable costs can change over time while fixed costs largely remain constant. Even if some costs shift each year, such as for rent and salary payments, they generally aren’t affected by production and sales levels. As a result, fixed costs can be easier to predict and budget for.

Examples of fixed business costs include:

• Lease payments. The cost of renting an office or retail space can remain fixed for at least a year, and sometimes longer depending on the lease terms.

• Insurance premiums. Your vehicle, rental, and business insurance payments should be predictable from month to month.

• Salaries. Employee payments can be negotiated in advance and agreed to for at least a fiscal year.

Calculating variable costs

As prices and sales volumes rise and fall, it's important to understand how to calculate and forecast your variable expenses.

For this, you can use a simple variable cost formula:

Total variable cost = variable costs per unit X number of units made ¹

For example, an automotive parts manufacturer determines that each vehicle headlight incurs a production cost of $30. Should the firm produce 150,000 additional vehicle headlights, the variable expense would be 150,000 X $30, resulting in a total of $4.5 million in variable costs.

The importance of variable cost analysis

A variable cost analysis can help a business understand how expenses fluctuate over time, which directly impacts operational efficiency and profitability. If you’re able to predict or prepare for changing business costs, for example, you can better forecast your spend and revenue.

Diving in deeper, conducting a variable cost analysis can inform:

• Budgeting for small businesses. Especially for businesses with fluctuating sales seasons, understanding variable costs can help you create more accurate and targeted budgets. For instance, your budget might include reserves for variable costs, such as energy bills and payment processing fees. Any leftover funds can be rolled into next year’s budget or saved for emergencies.

• Product pricing and break even points. Once you know the costs involved in production, you can set your retail prices accordingly. For example, you can conduct a break even analysis to determine how many products you’ll need to sell at a certain price to cover your costs. You can then set your prices above that point to turn a profit.

• Business growth strategies. By analyzing variable costs, a business may be better prepared to make smart investments or implement cost-cutting strategies to fuel growth. Say you know you’re entering a slow season when your hours of operation will be shorter, lowering your utility bills. You might use that money you’ll save on bill payments and put it towards new product testing or marketing outreach campaigns.

How can you use variable costs to determine your gross profit margin?

You can calculate your gross profit margin to help assess your business's financial health using this formula:

Gross profit margin = (net sales - COGS) / net sales ²

Essentially, the gross profit margin calculates how much profit a business made after accounting for the costs of goods or COGS. Some COGS are variable expenses, such as raw materials, shipping costs, and production labor. That’s why tracking your variable costs can help you calculate your gross profit margin and better understand your business finances.