Few things in life never change, including the costs of doing business. When expenses change in relation to the activities of your business, these are known as variable costs. Variable costs can be defined as the total of all marginal costs divided by the number of units you produce. Because variable costs vary with the number of units being made, they are also called unit-level costs. In most cases, the cost of producing any item increases at a rate proportionate to labor and capital required. Whatever your business produces, you should have a firm understanding of your variable costs and how they relate to the total cost of doing business.
To understand variable costs, it helps to understand how they compare to fixed costs. Suppose, for example, you made wooden toys in a workshop. Many expenses would be the same every month, including the building lease, equipment rentals and the wages paid to salary employees.
Variable costs would include anything that changes in proportion to the number of toys you make each month. These would include raw materials like wood, glue and paint, as well as the wages paid to hourly employees.
Some costs have both a fixed and variable component. There would be a fixed cost for electricity, for example, since simply opening the shop and turning on the lights would be the same every month. However, there would also be a variable cost component dependent on how many hours you operated saws, lathes and other production equipment.
It's difficult to know how much to charge your customers if you don't know what the variable cost per unit is. To begin, you should determine what all of your costs are, separating the fixed costs from the variable costs for a fixed period of time or for a specific production run. The variable cost varies for each type of product you make. In our toy workshop example, the cost of making wooden soldiers would be different from making doll houses, because the amount of materials and labor would be different. Suppose, in this example, you made 2,000 wooden soldiers this month, and your costs were as follow:
- Fixed costs (lease, insurance, utilities, etc): $5,000
- Materials used for production: $1,000
- Labor used for production: $2,000
Total costs for the month would be $8,000; however, the variable cost would be $3,000.
To calculate the variable cost per unit, divide $3,000 by 2,000 units, which is $1.50 per unit. The formula for calculating the variable cost per unit is:
Variable Cost Per Unit = Total Variable Cost / Total Units Produced
While it is always important to factor in fixed costs when looking at the costs of anything you produce, they are usually separated from variable costs. They can be factored in again when calculating the costs for everything you produce. For example, if you made 2,000 doll houses in addition to the wooden soldiers in a month, with a total production of 4,000 toys, then the $5,000 fixed costs for the month could be divided by 4,000 for a cost of $1.25 per unit. Thus the total cost per unit for the wooden soldiers would be $1.75 per unit.
Once you have determined the variable cost per unit, it's simply a matter of multiplication to calculate the total variable cost for producing quantities of any item:
Total Variable Cost = (Total Number of Units) * (Variable Cost per Unit)
Always keep in mind that you need to factor in the fixed costs before determining a price for any order.