Some of the expenses you incur running your business are unlikely to change no matter how savvy or proactive you may be. Rent needs to be paid and business licenses come due at the beginning of each year, and these cost the same whether your business is thriving or struggling. However, the direct expenses of labor and materials – the cost of creating products and services and delivering them to customers – vary more or less relative to how much business you transact.
Understanding variable costs helps you to plan and prepare, especially when it comes to proactively securing financing for increased expenditures when you anticipate spikes in demand.
Calculating Variable Cost
If your business is new and you have no previous records to go by, you can calculate variable costs by researching the price of the materials that will go into creating your offerings and then dividing the cost of each batch by the number of units in that batch.
To estimate the cost of labor:
- Multiply the number of hours you expect it will take to produce each batch by the wage you’ll pay per hour to calculate the total labor cost for the batch.
- Divide the labor cost for the batch by the number of units in the batch.
If your business has been operating long enough to track these expenses from actual experience, use bookkeeping and payroll records to determine how much you’ve spent on materials and labor, and divide these figures by the number of units you’ve produced to determine the cost per unit.
Although the process of calculating variable costs often assumes that the relationship between the expense per unit and the number of units produced is linear, this may not be the case. When your business is able to leverage economies of scale, the cost per unit decreases as you buy materials in volume or your staff is able to produce more during each shift. Although labor is often logged as a variable cost, the reality is actually more complex. Your business may need a skeleton staff to keep things running whether or not you have orders or customers. The cost of keeping this skeleton staff on board is more of a fixed cost than a variable one, although it’s tricky for a bookkeeping system to separate these two aspects of your payroll.
Cost per Unit
Calculating variable cost gives you only one part of the equation when figuring the total expense you incur to produce each item you sell. The complete equation should also include fixed costs such as overhead and business licenses, which remain relatively stable overall relative to the number of units you produce. Unlike variable cost per unit, which is reasonably consistent per unit and correlates directly with the number of units you produce, your overall fixed costs stay constant, but the cost per unit declines as you divide these costs by a greater number of units.