Variable Costs

What it is:

Variable costs are corporate expenses that vary in direct proportion to the quantity of output. Unlike fixed costs, which remain constant regardless of output, variable costs are a direct function of production volume, rising whenever production expands and falling whenever it contracts. Examples of common variable costs include raw materials, packaging, and labor directly involved in a company's manufacturing process.

The formula for calculating total variable cost is:

Total Variable Cost = Total Quantity of Output x Variable Cost Per Unit of Output

The term variable cost is not to be confused with variable costing, which is an accounting method related to reporting variable costs.

How it works/Example:

Let's assume XYZ Company 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. First, the variable costs per widget must be determined.

Let's assume the following:

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

From this information, we can conclude that each widget costs 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 above, we can calculate that XYZ Company's total variable cost on the order is:

5,000 x ($0.10 + $0.50) = $3,000

Therefore, the company can reasonably expect to earn a $2,000 gross profit ($5,000 - $3,000) from the order.

Why it Matters:

While fixed costs, such as rent or other overhead, generally remain level, variable costs will correlate with the number of products manufactured. Because average variable costs differ widely among industries, comparisons are generally most meaningful among companies operating within the same industry.

When analyzing a company's income statement, it should be remembered that rising costs are not necessarily a troubling sign. Whenever sales rise, more units must first be produced (excluding the impact of stronger pricing), which in turn means that variable production costs must also increase. Thus, for revenues to climb, expenses must also rise accordingly.

It is important, though, that revenues increase at a faster rate than expenses. If, for example, a company reports volume growth of 8%, while cost of goods sold (COGS) only rises 5% over the same span, then costs have likely declined on a per unit basis. If a company can find ways to reduce the input costs associated with producing each item it sells, then its profitability will improve. One way to monitor this aspect of a company's business is to divide variable costs by total revenues to figure costs as a percentage of sales.

Variable costs frequently factor into profit projections and the calculation of break-even points for a business or project. Some costs change in a piecewise manner as output changes and therefore may not remain constant per unit of output. Also, note that many cost items have both fixed and variable components. For example, management salaries typically do not vary with the number of units produced. However, if production falls dramatically or reaches zero, then layoffs may occur. This is evidence that all costs are variable in the long run.

A company with a large number of variable costs (compared to fixed costs) may exhibit more consistent per-unit costs and hence more predictable per-unit profit margins than a company with fewer variable costs. However, a company with fewer variable costs (and hence a larger number of fixed costs) may magnify potential profits (and losses) because revenue increases (or decreases) are applied to a more constant cost level.

Part of being a successful investor involves making an educated forecast about how a company will respond under different operating conditions, and one of the key determinants is the proportion of fixed costs to variable costs. 

Margin analysis will help you identify companies that can best convert sales into profits. See examples of how to use this technique in How to Use Margin Analysis as an Investment Tool.

Best execution refers to the imperative that a broker, market maker, or other agent acting on behalf of an investor is obligated to execute the investor's order in a way that is most advantageous to the investor rather than the agent.