Variable cost definition
/What is Variable Cost?
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 total 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. 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.
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Types of Variable Costs
The most common variable costs are as follows:
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.
The Difference Between Variable Costs and Fixed Costs
A fixed cost is one that you will incur even in the absence of any business activity, while you will only incur a variable cost if there is business activity. This leads to the following differences between the two concepts:
Influence of activity volume. A variable cost will vary with changes in activity volume, while a fixed cost will not. For example, when goods are produced, the cost of materials is considered a variable cost, since materials are only consumed when production occurs. Conversely, the depreciation cost of the equipment in the factory will be incurred, irrespective of the production volume within the facility, and so is considered a fixed cost.
Impact on profits. Variable costs will increase as the number of units sold increases, while fixed costs are incurred irrespective of the number of units sold. This means that fixed costs have a large impact on profit levels when the sales volume is low, and no impact when sales volumes increase.
Financial reporting. Variable costs are mostly reported within the cost of goods sold section of the income statement, while fixed costs are more likely to be reported within the operating expenses section of the statement.
FAQs
Are variable costs always linear?
Variable costs are not always perfectly linear. They are often assumed to change proportionally with activity within a relevant range, but real-world conditions may cause deviations. Bulk purchasing discounts, capacity constraints, labor inefficiencies, or overtime premiums can cause variable costs to increase or decrease at different rates as production levels change.
Is overhead a variable cost?
Overhead is generally classified as a fixed or mixed cost rather than a purely variable cost. Many overhead items, such as rent, administrative salaries, and insurance, remain constant regardless of production volume. However, some overhead components, such as indirect materials or utilities, may vary with activity levels.
Is direct labor a variable cost?
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 fully staffed, irrespective of the amount of production volume. This is a common situation in large and complex assembly lines, where all positions must be staffed before operations can commence.