Understanding variable costs for businesses

Understanding variable costs and their potential impact on a business is essential for any entrepreneur looking to start or grow a company.

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 also pivotal in determining a business's gross profit margin, a key indicator of financial health. Below are some key characteristics of variable costs:

Dependence on production levels

Take a restaurant, for example. During busy times and seasons, it may need more waiters and cooks. The cost of having more staff goes up when there are more customers, which makes staffing a variable cost that can change with demand.

Pricing and profit margins

Used for determining pricing strategies, variable costs impact the cost of goods sold and, in turn, the profit margin of each unit sold.

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 several types of variable costs a business may encounter. Let’s look at some common examples:

• Raw materials. Used to directly make 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.
• Sales commission. As sales increase, commission 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. fluctuate with the volume of transactions.

Variable costs based on business activities

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

• If a business has a large sales team, the commission paid may soar during periods of increased sales.
• For a manufacturing company, an uptick in production can lead to more hours of operation, resulting in greater utility and labor costs.
• A consulting firm may see more costs for travel or accommodations when visiting clients.

Calculating variable costs

As prices and sales volume rise and fall, it's important to understand how to calculate and forecast costs. Here’s a simple variable cost formula:

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

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 costs fluctuate over time — which directly impacts operational efficiency and profitability. Areas where variable costs play a role include:

• Budgeting. Particularly useful for businesses with fluctuating sales seasons, understanding variable costs enables an organization to create more targeted budgets.
• Pricing. Knowing the costs involved in production ensures retail prices cover all expenses while turning a profit.
• Growth. By analyzing variable costs, a business may be better prepared to make smart investments in growth or implement cost-cutting strategies.

Managing business finances and variable costs

Whether setting prices, forecasting cash flow, or making growth decisions, understanding variable costs is critical for managing a profitable business. Discover how a PayPal business account can help your business grow.