Variable Cost Formula Explained

If you are familiar with economics and entrepreneurship at least a bit, you likely know what business "costs" mean. They’re expenditures that are necessary in order to keep your business afloat. But are you aware that there are actually two types of costs - fixed and variable? Nope? Well, you came to the right place, because in this article we’ll be going over the latter - variable costs. Our goal is to look at the variable cost formula, explain it, and get into a little bit more detail to help you get more insights for your business to do better!

As we’ve mentioned, your business has costs to cover in order to keep running. There are two types of costs and having the ability to monitor, cut down and alter the total costs is a great way to optimize your business’ performance.

Fixed costs (also known as overhead, indirect costs), unfortunately, aren’t up for optimization. So, for example, the rent you pay for the company office is a form of fixed costs. Salaries paid out to employees are too. They aren’t avoidable and aren’t impacted by the productivity of your business.

Variable costs, on the other hand, are directly linked to the size, efficiency, and practices of your business. There are so many ways to reduce, change up, add new or eliminate variable costs, that both finance and accounting specialists, as well as small company owners, should be able to handle this topic and be knowledgeable in it. Not to mention being able to calculate it! Below is a graphic where we show what variable and fixed costs are (with examples).

There are some economic principles that explain (very basically) how variable costs work. Small businesses usually have very small variable costs (in terms of relation to total costs). It’s usually fixed costs that take up the vast majority of the spending chart. However, as a business grows, so do its variable costs. They are always linked to direct outputs of production. So, let’s say Coca-Cola would likely have much higher variable costs than your local soda manufacturer.

Variable costs should always be monitored. By knowing and keeping track of your ad, commission, equipment, and any other variable cost-related spending, your business can prosper on a whole new level. Variable cost reduction can usually be done by implementing state-of-the-art technology, decentralizing, or centralizing certain decision-making processes (the right choice depends on a lot of factors), adding more workforce, and improving management.

The easiest way to reduce a lot of variable costs is to just look for automated or modern software solutions. So, for example, instead of only replying to inquiries by email, you can use Atlasmic to always keep in touch with your customers. It helps simplify the work of your customer support by offering a user-friendly interface for chatting and streamlines data flow within your organization, related to customer inquiries, complaints, requests, etc.

If you want to calculate variable costs, you can use a simple formula. It looks like this:

This formula, however, only shows a very superficial figure which doesn’t tell you a whole lot. This helps you calculate Total Variable Costs (TVC). But that’s just the tip of the iceberg. If your company is in manufacturing, you need to also know how to figure out the average variable cost of one unit made or the whole average variable costs for total production outputs. Here’s the formula for that:

Why is it important to keep track of both metrics? Let’s explain in the next paragraph!

As we’ve said, fixed costs are sort of set in stone. Do whatever you like, they’re almost impossible to reduce without feeling severe repercussions from your staff (e.g. because of reduced salaries) or diminishing productivity (e.g. because you decided to rent a smaller warehouse with less equipment).

But the whole idea of a profitable business revolved around income being higher than your costs. Raising the prices is always quite a challenge, so businesses are continuously looking for opportunities to reduce their expenses. That starts off by knowing exactly how much they spend, where it’s being spent and how much of that can they reduce without damaging profits.

Let’s use an example. Let’s say that a company makes sneakers. It spends, on average, 2.00$ per pair sold, on advertising. It sells 10,000 pairs a month or 120,000 pairs a year. That’s 20 thousand dollars every month, just on advertising sneakers. Ad executives could strive to optimize advertisements and ad strategies to reduce the total variable costs to 1.5$ per pair sold. If the attempt is successful, this example company could save 60,000$ each year. That’s just not doable without knowing where you can reduce spending and which areas could be improved. Besides, if the advertising team would set out to achieve such a goal, they would need to constantly monitor the variable costs to know, how much more they need to cut spending, in order to reach their objective.

Of course, we hope this article was useful, but let’s just summarize things for maximum benefit. So, variable costs are one of two types of costs that a business faces. They are usually directly correlated with the size of your business, meaning the more you produce, sell, do, the higher your variable costs are. Calculating variable costs is very simple, you just have to subtract the fixed costs from the total amount of money you’re spending. And finally, monitoring them is very beneficial. Your business can save thousands upon thousands of dollars annually, by knowing which areas could be improved.