- Variable costs are one of the two main categories of costs in business, alongside fixed costs.
- They are costs that vary proportionately with the level of production or sales. In this set of notes, we will explore the features and importance of variable costs.
Features/Characteristics of Variable Costs:
- Variable costs increase or decrease with changes in production or sales volume. Example: Raw materials costs for a manufacturer will increase as more units are produced.
- Variable costs are directly proportional to the level of activity. Example: Sales commissions for a salesperson will increase as the amount of sales made increases.
- Variable costs are usually expressed on a per-unit basis. Example: The cost of ingredients in a restaurant is typically calculated per dish.
- Variable costs can be easily controlled by changing the level of production or sales. Example: If a company wants to reduce its variable costs, it can produce fewer units or sell fewer products.
- Variable costs are different from direct costs, which are costs specifically associated with producing a product or service. Example: The cost of materials used to create a product is a direct cost, while the cost of shipping the product is a variable cost.
- Variable costs are also different from overhead costs, which are costs not directly associated with producing a product or service. Example: Rent is an overhead cost, while the cost of raw materials is a variable cost.
- Variable costs are important in determining a company’s gross margin. Example: If a company has high variable costs, its gross margin will be lower than a company with low variable costs.
- Variable costs are important in pricing decisions. Example: A company must consider its variable costs when setting a price for a product or service.
- Variable costs are also important in decision-making regarding production levels. Example: If a company wants to increase its production, it must consider the additional variable costs that will be incurred.
- Variable costs are sometimes referred to as direct variable costs, to differentiate them from indirect variable costs which may not be directly linked to the production or sales volume.
Importance of Knowing Variable Costs:
- It is important for businesses to know their variable costs because it helps them in several ways:
- It helps in pricing decisions, ensuring that prices cover variable costs and leave enough margin for profits.
- It helps in cost control, by identifying areas where variable costs can be reduced without affecting quality or quantity.
- It helps in forecasting profits and sales, as variable costs can be factored into revenue projections.
- It helps in decision-making regarding production and sales levels, ensuring that variable costs are covered while maximizing profits.
