A variable cost is a cost that varies in relation to changes in the volume of activity. A variable cost increases as the level of activity increases; for example, the cost of direct materials goes up in conjunction with increases in production volume. The variable cost concept can be used to model the future financial performance of a business, as well as to set minimum price points. The most common variable costs are:
- Direct materials, since the cost of materials are charged to expense when the associated products are sold.
- Commissions, since the sales staff earns commissions when sales transactions are completed.
- Billable labor, since wages associated with billable hours are charged to expense when the associated sales transactions are completed.
- Piece rate labor, where employees are paid based on the number of units produced.
- Credit card fees, where a fee is not incurred unless a customer uses a credit card to pay for a purchase.
- Utility costs, which increase as production and/or employee headcount increase.
Direct labor may not be a variable cost if labor is not added to or subtracted from the production process as production volumes change. This situation arises when a production line must be staffed, irrespective of the amount of production volume.
Overhead is not a variable cost, since overhead costs will be incurred, irrespective of production levels. For example, both rent and machine depreciation, which are overhead costs, will be incurred even if there is no production activity.
A company with a high proportion of variable costs can usually generate a profit at a relatively low sales level, since there are few fixed costs that must also be paid for in each accounting period.