## Table of Contents

- Variable Cost
- Average Variable Cost
- Average Fixed Cost
- Average Total Cost
- Applications of Variable Cost
- Summary

Understand variable cost in business. Learn the definition of variable cost, the variable cost formula, and how to use the formula to calculate the variable cost.
Updated: 02/15/2022

- Variable Cost
- Average Variable Cost
- Average Fixed Cost
- Average Total Cost
- Applications of Variable Cost
- Summary

The** variable cost** definition in business accounting means any expense that changes dependent on the amount of products being produced. Variable costs can increase in one month and then be lower the next month depending on the business's overall production. A general business rule for variable costs is if a production is high, variable costs are high and vice versa. Variable cost involves indirect and direct cost. **Direct costs** are costs that are directly related to the production of a product. **Indirect costs** are expenses that are not directly related to the production process but are related to the servicing of the product during or after its produced. Businesses use a variable cost formula to calculate for variable cost.

There are many variable cost examples, and variable costs are unique to each business. Common variable cost examples seen in businesses include:

- Labor
- Utilities (energy and water)
- Supplies
- Shipping and handling costs
- Marketing
- Sales related costs
- Transaction fees like bank fees and credit card fees
- Raw materials

Fixed costs differ from variable costs. The **fixed cost** definition in accounting describes expenses that stay constant no matter how much is being produced. Fixed costs will remain the same when business activity is high or low. Fixed costs are not usually direct costs that are involved in the production process. Variable costs are usually consumable items that changes when the volume of production changes.

Common fixed cost examples include:

- Rent on property
- Insurance
- Storage fees
- Loan payments
- Equipment rentals
- Asset depreciation

**Total cost** is the final total costs to produce a product during a set time period. To find total costs, a business must find the total variable costs and fixed costs. The total cost formula is *Variable costs + Fixed Costs = Total cost. *

For example:

An apple orchard business spent $10,000 on fixed costs for the month of September. In the same month, their variable costs totaled to be 27,532. The apple orchard accountant wants to calculate for the total costs before the end of the season.

10,000 + 27,532 = $37,532 in total costs for the month of September.

To find variable cost, a business must use the variable cost formula. To find variable cost a business must find the cost per unit and the output quantity in the time period in which they are calculating for.

The** variable cost formula **is: *Total variable cost = total quantity of output X variable cost per unit of output*

For example: A start-up company makes 100 products in one month and it each product costs $5.00 per unit. The business wants to sell these products for $20 a piece. To calculate for variable cost this month, the formula would like: 100 x 5 = $500 total variable cost.

The fixed cost equation is: *Fixed costs = Total cost of production - (Variable cost per unit x Number of units produced)*. In order to calculate for fixed costs, the a business must:

- Add up all the costs in the time period they are targeting.
- Organize fixed costs and variable costs.
- Take the variable cost of each unit multiplied by the number of units produced.
- Find fixed costs bytaking the total costs of production minus the variable cost found in step three.

The sum of the variable cost and the fixed cost formulas yields the total cost formula.

The total cost formula is: *Total cost = Total Variable Cost + Total Fixed Cost*

Total cost calculation example: A business experiences $50,000 total variable costs and $25,000 fixed costs for one month of business activity. To find total cost: 50,000 + 25,000 = $75,000 for total costs in that month.

The **average variable cost** definition is the **variable cost per unit**.

The formula to find the variable cost per unit is: *Average Cost Per Unit = Variable Cost / Quantity produced*

For example: A business that has $400 in variable cost for one month and is producing 20 products in that month would experience $20 variable cost per unit. 400/20 = 20.

The average fixed cost definition is the fixed cost per unit produced.

The fixed cost per unit formula is: *Average Fixed Costs = Total fixed costs / Quantity produced*

For example: A business has $100,000 in total fixed costs and they produced 10,000 items in a month. 100,000 divided by 10,000 = $10 average fixed costs.

The **average total cost** definition is the** total cost per unit** produced in a given time period.

Two ways to find the total cost per unit:

- Average Variable Cost + Average Fixed Cost = Average Total Cost
- Total Production Cost / Quantity of production = Average Total Cost

Here is an example of both methods:

- First method: $5.00 + $6.25 = $11.25 Average total cost
- Second method: $200 divided by 40 items = $5 Average total cost

There are different applications of the variable cost in the cost-volume-profit analysis for a business. Variable cost formula can help calculate total variable manufacturing cost involved in business operations. These applications include:

- Contribution margin - Business selling price per unit minus the variable cost per unit. This helps determine, at the margin, how profitable a business is.
- Breakeven point - Once a business has calculated their contribution margin, they can then calculate the breakeven point using this formula: Fixed costs divided by contribution margin equals breakeven point. This helps determine if a business revenue is meeting, or exceeding, business expenses.
- Sales on a target profit - The formulas for target profit are different for each business depending on how many products they produce and sell. Calculating target profit is important for a business to determine what they need to price their product at, and how many of each product they need to sell, in order to profit.
- Shut-down decision - Businesses make a shut-down decision to cancel a product, close a department, or shut down their business if their marginal costs begin to outweigh revenue in the long run. For a business to operate, revenue > total costs.

**Variable costs** in a business are indirect and direct costs that fluctuate proportionally with the fluctuation of output. **Direct costs** are costs directly involved in the production process, like raw materials. **Indirect costs** are costs associated with the servicing of a product after its production, like marketing. Common variable cost examples are materials, labor, and sales commissions. **Fixed costs** are business costs that remain constant from month to month, no matter how much production changes. **Total cost** is the sum of the variable costs plus fixed costs.

The ** variable cost formula **is: *Total variable cost = total quantity of output X variable cost per unit of output*

The **average variable cost formula** calculates the **variable cost per unit**. *Average Cost Per Unit = Variable Cost / Quantity produced. *A business can use the variable cost per unit and add it to the fixed cost per unit to find the** average total cost** or **total cost per unit**. Variable cost can be applied in business accounting to help find contribution margin, breakeven point, target profit, and determine a shut-down decision.

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- Activities
- FAQs

The following exercise is designed to help students apply their knowledge of variable cost and its formula in a real-life scenario.

You are a management consultant specializing in cost management. Your newest client, Beauty Ice Cream ("Beauty"), is a local ice cream shop that sells homemade, artisanal ice cream in a small location just off the college campus in Cambridge. Beauty is looking for help because it wants to better understand its cost structure. You have the following voice notes from your interview with Milky Dairy, the owner of the shop.

"You would think an ice cream shop is a simple business, but we cannot turn a profit. It's driving me insane. I need some help understanding my cost structure so that I can make better decisions."

"We don't have that many costs: We buy the ice cream in bulk from a local ice cream maker, it comes out to roughly $0.40 per scoop. We then buy our cones at $1 for a pack of 10 units. We add our special frosty sprinkles, which cost $0.10 per scoop on average. Besides that, our rent is $900 per month, or $30 per day. We pay our only employee $10 per hour for 8 hours, or $80 per day. We sign an annual contract with her and I would never fire her. That's all we have."

1. What is the total variable cost per unit (assuming one scoop per cone sold)?

2. Determine the variable cost function of Beauty.

3. If the company were to sell 500 units, how much would its total variable cost be?

**1.** See below.

Item | $ |
---|---|

Ice cream | 0.40 |

Sprinkles | 0.10 |

Cones =$1/10 | 0.10 |

Total variable cost | $0.60 |

The other costs are fixed in nature.

The answer is thus 60 cents per unit.

**2.** Total variable cost = Ice cream cones sold * $0.60

**3.** Total variable cost = Ice cream cones sold * $0.60

= 500 * 0.60

=$300

The answer is $300.

A variable cost example is anything directly related and consumed during production. Raw materials, labor, and supplies are common variable cost examples.

Fixed costs = Total cost of production - (Variable cost per unit x Number of units produced). Variable cost = total quantity of output X variable cost per unit of output

The formula for variable costs is: total quantity of output X variable cost per unit of output = variable cost. A business would need to find this data for a set time period.

Fixed cost examples are expenses like rent, storage, and insurance fees. Variable costs examples are direct labor, materials, supplies, and energy used in the production process.

The variable cost per unit formula is the same as the average variable cost formula. It is Average Cost Per Unit = Variable Cost / Quantity produced.

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