Sooner or later, all growing businesses face the problem of rising production costs. The more successful your business is, the more the demand for its products or services grows, and expenses follow. Unfortunately, the cost of producing more doesn’t have to scale proportionally to your profits.
The more sales you make, the more you have to invest back into the business. This includes marketing, raw materials, labor, and investing in new products and prospects. Knowing how to find the variable cost is essential for businesses that want to grow without being overwhelmed by the demands of upscaling production.
What Is a Variable Cost?
A variable cost is an expense that directly depends on how much of a specific product your enterprise manufactures or sells. These costs directly depend on the volume of goods. With increased demand, there are more expenses, and with a reduced trading volume, the expenses are lowered.
The number of raw materials needed for production can vary depending on the number of orders your business receives. Furthermore, the price of materials can also fluctuate with market changes. With more goods, you need more packaging, online sales incur more transaction fees, and you need additional labor to meet the demand.
Variable Cost Formula: Calculating Total Cost and Cost per Unit
Variable cost, by definition, is the total sum of materials and labor needed to manufacture a unit of product.
Variable Cost per Unit = Materials + Labor
Your supplier may change the price of the material, or the labor market may force you to adjust the wages. That’s why the cost of making your product isn’t a fixed value and will likely change over time.
Total Variable Cost vs. Average Variable Cost
The total variable cost is equal to the sum of all costs per unit, for all units.
Total Variable Cost = Variable Cost Unit 1 + Variable Cost Unit 2 + … + Variable Cost Unit N
The total value of creating a series of products is represented in the equation above, and it’s the sum of each individual product manufactured, where N equals the total number of units.
You can multiply the cost of a single product you manufacture by the total number of units you plan to produce to get an approximate value for the total variable cost. If the expenditure per product doesn’t vary as much, you can calculate the total variable cost as a multiplication of the value per unit and the number of units.
Total Variable Costs = Variable Cost per Unit x Number of Units
The total variable cost formula isn’t as precise as the total sum of all costs. However, it can be less time-consuming and easier to calculate since it doesn’t involve keeping expense records of each product your business produces.
If there are bigger cost variables between products you manufacture, then you should calculate average variable costs. This value will help make ballpark calculations of how much funds you need to put aside to fulfill an order that requires a certain number of units to produce.
Average Variable Cost = (Variable Cost Unit 1 + Variable Cost Unit 2 + … + Variable Cost Unit N) / Total Number of Units
Examples of Variable Costs
These are the most common types of expenses you can expect for your small business:
- Production materials – If your business manufactures anything for monetary gain, you will have to account for the cost of materials needed for the end product. Whether you are making clothes or you are running a food business, the same expenses will apply. They directly depend on the number of orders and customers.
- Equipment – If your current production can’t keep up with the demand, you will need to invest in increasing the manufacturing output.
- Wages – With more work, you’ll need more employees, which leads to a higher payroll.
- Transaction fees – Payments made with credit cards incur processing fees that usually take anywhere from 1.5% to 3.5% of your profits. This also applies to other online payment processors such as PayPal.
- Shipping and packaging – These figures are directly related to the number of sales you make, as each product needs to be safely packaged and shipped, incurring additional expenses. Trying to save money on these categories may result in shipping damaged goods and having to refund your customers.
These are just some of the examples of variable costs you can expect. Some unforeseen expenses can always pop up and disrupt your monthly bottom line. That’s why having business insurance helps, even though it adds to fixed monthly expenses.
What Is a Fixed Expense?
Unlike variable costs, fixed expenses don’t depend on the growth of your trading volume. These are recurring charges like interest payments, rent, insurance, utilities, website hosting, etc. Depending on the type of business, an expense may be seen as a fixed cost of doing business.
These expenses are considered fixed because they don’t depend on the success of your business. However, while your utility costs may stay the same, you may decide to change the facility you are renting, which will lead to increasing fixed costs.
There are ways to reduce your fixed overhead, as many companies want to help emerging firms and create long-term partners. One such factor is affordable hosting for your online business. Good server infrastructure can make the difference between a successful and a failed startup.
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How Can Variable Costs Affect Growth and Profitability?
Knowing the variable manufacturing costs will help you understand your end price. Both fixed and variable costs need to be taken into account, but remember that payments that stay the same, like rent, have less of an effect than payments that change.
You need to be able to accurately calculate variable costs and make decisions that won’t hurt your profit margins for the production process to work. Maybe some products or services you’re offering are less profitable than others, so it pays off more to remove them from your offer and allocate resources to more profitable ones.
Alternatively, you can examine what variables prevent the product from being more profitable. Maybe you can source the materials from a different company for a lower price or make a one-time investment in better equipment to make the manufacturing process more efficient.
Whatever the case, knowing how to find the variable cost per unit can help you plan your production and grow your small business while successfully scaling it to meet demand.
The market’s prices constantly change. Therefore, adjusting your budget will help you improve your bottom line and help your business stay afloat.