Businesses live or die based on sales volume and how well they control costs. However, before you can effectively manage expenses and eliminate waste, you have to know what your business is spending and for what. Tracking variable costs is an essential part of this management function. Such costs comprise a major part of overall operating expenses and help determine whether or not a product is profitable.
Variable and Fixed Costs
The expenses a business incurs in the process of conducting its operations can be divided into two categories: fixed and variable costs. The term “fixed costs” refers to expenditures that must be paid even if the business isn’t operating. Examples of fixed costs are rent, insurance payments and compensation for administrative and management staff. Variable costs are expenses tied to producing, acquiring and selling products or services. Unlike fixed costs, which are relatively constant, total variable costs change with the level of production or sales.
Types of Variable Costs
In a retail setting, variable costs may be relatively uncomplicated. For example, a shoe store’s variable costs might only consist of inventory purchased for resale, plus an allowance for lost or damaged items. For a manufacturing enterprise, variable costs typically are more complex. Some common variable expenses are:
- Raw materials
- Wages for production labor
- Inventory financing costs
- Product packaging
- Sales commissions
- Energy costs for production processes
Unit Variable Cost
The formula for calculating unit variable costs is total variable expenses divided by the number of units. Suppose a company produces 50,000 widgets in a year. Variable expenditures might consist of:
- Raw materials..........$350,000
- Production labor......$250,000
- Shipping charges.....$50,000
- Sales commissions..$100,000
Total variable expenses add up to $750,000. Divide total variable expenses of $750,000 by the production quantity of 50,000 widgets and you come up with a variable cost per unit of $15.
Using the Variable Cost Metric
Tracking variable costs is useful for managers who want to document where company money goes, and also is useful for calculating break-even sales volume and for evaluating pricing levels. Break-even sales volume is the number of units a firm must sell to exactly cover total operating costs. Suppose a firm sells widgets for $40. The variable cost per unit equals $15. Fixed costs are equal to $700,000 for a year. Subtract the variable cost per unit of $15 from the $40 price, leaving $25. Divide fixed costs by $25 and you have a breakeven sales volume of 28,000 units. If the company doesn’t expect to sell enough additional units to provide an adequate profit, management will want to re-evaluate the pricing strategy, company sales goals or both.
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