How to Prepare a Break Even Analysis
Cheif Financial Officer (CFO)
Absorption Cost Accounting
Variable Cost Definition
In accounting, variable costs are costs that vary with production volume or business activity. Variable costs go up when a production company increases output and decrease when the company slows production. These costs may also be called unit-level costs. Variable costs are in contrast to fixed costs, which remain relatively constant regardless of the company’s level of production or business activity. Combined, a company’s fixed costs and variable costs comprise the total cost of production.
In accounting, all costs can be described as either fixed costs or variable costs. Variable costs are inventoriable costs – they are allocated to units of production and recorded in inventory accounts, such as cost of goods sold. Fixed costs, on the other hand, are all costs that are not inventoriable costs. All costs that do not fluctuate directly with production volume are fixed costs. Fixed costs include various indirect costs and fixed manufacturing overhead costs. Variable costs include direct labor, direct materials, and variable overhead.
Variable Cost Example
For example, imagine a company that manufactures widgets. The company has a factory and laborers. The company purchases one unit of raw material for each widget it makes. Each widget requires one hour of labor. Each unit of raw material costs one dollar and each hour of labor costs $10.
This company’s variable costs, according to the example, would be the costs associated with purchasing raw material and the wages paid to laborers. When business is booming, the factory makes 1,000 widgets per day. Therefore, variable costs for raw materials and labor when business is good would be $1,000 for units of raw material and $10,000 for labor wages per day.
When business is slow, the company only makes 500 widgets per day. In this case, the daily raw material costs would be $500 and the daily labor costs would be $5,000. The variable costs associated with production fluctuate with the volume of production. More production volume means more variable costs, and less production volume means less variable costs.
Fixed costs, on the other hand, such as rent and utilities for the factory, remain constant whether the company is producing 1,000 widgets per day or 500 widgets per day. Fixed costs do not fluctuate with production volume.
Variable Costs and Decision-Making
When making production decisions, managers will often consider only the variable costs related with the decision. Since fixed costs will be incurred regardless of the outcome of the decision, those costs are not relevant to the decision. Only costs that will or will not be incurred as a direct result of the decision are considered. And these relevant costs are the variable costs.
If you want to find out more about how to utilize your unit economics to add more value to your organization, then click here to download the Know Your Economics Worksheet.
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