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Variable Cost

See Also:
How to Prepare a Break Even Analysis
Cheif Financial Officer (CFO)
Cost Accounting
Yield Curves
Financial Ratios
Absorption Cost Accounting

Variable Cost

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.

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variable cost

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Contribution Margin Definition

See Also:
Margin vs Markup
Segment Margin
Marginal Costs
Segmenting Customers for Profit
Financial Ratios

Contribution Margin Definition

Contribution margin (CM), defined as selling price minus variable cost, is a measure of the ability of a company to cover variable costs with revenue. The amount leftover, the contribution, covers fixed costs or is profit.

Contribution Margin Meaning

Contribution margin means a measurement of the profitability of a product. In addition, express it as a dollar amount per unit or as a ratio. CM can be calculated for a product line using total revenues and total variable costs. It can also be calculated at the unit level by using unit sales price and unit variable cost. The metric is commonly used in cost-volume-profit analysis and break-even analysis.

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Contribution Margin Formula and Contribution Margin Ratio Formula

Use the following contribution margin formula below:

CM = Unit Price – Unit Variable Cost

The contribution margin ratio, or contribution margin percentage, is the CM expressed as a percentage of the unit sales price. Calculate it using the following formula:

CM Ratio = (Unit Price – Unit Variable Cost) / Unit Price

Contribution Margin Calculation

After you collect all the information, it is fairly easy to calculate CM. For example, a company has a $1,000 unit price and a $150 unit variable cost

Contribution margin per unit= $1,000 – $150 = $850

Contribution Margin Ratio Calculation

The contribution margin equation can also be applied to create a ratio for the given values. For example, a company has a $1,000 unit price and a $150 unit variable cost

CM = ($1,000 – $150) / $1,000 = .85

Contribution Margin: Income Statement

The CM format income statement is a variation on the standard income statement that separates variable costs and fixed costs. It starts with revenues, subtracts variable costs, and then displays the CM, as well as, the CM percentage before subtracting fixed costs and giving the net operating income. A simplified CM format income statement might look like this:

Revenue        $100,000

Variable costs
Raw material$15,000
Variable labor$20,000
Delivery charge        $5,000
Total variable costs$40,000
Contribution margin$60,000
Contribution margin percentage          60%

Fixed costs
Rent$25,000
Utilities               $5,000
Wages$20,000
Total fixed costs                               $50,000
Net operating income$10,000

Contribution Margin Example

Isabel is the CFO of a private company, the holding company for a series of retirement homes, called Retireco. She has known the owner of Retireco since she was a child, noticing her unique drive to make her company a success. Isabel has turned her family friend into a lifelong business connection and now, having earned her expertise in the accounting world, is her CFO.

One day the CEO of Retireco asks Isabel to calculate the CM of her company. Her purpose is to know variable costs, fixed costs, and finally profit are derived from sales. Since she is familiar with it, this is a simple task.

Isabel begins by collecting all of the company financial records. Once she has done this, she sits down to perform CM analysis. Here, she finds a per unit value:

$1,000 unit price and a $150 unit variable cost

CM = $1,000 – $150 = $850

Isabel then converts this number to CM ratio:

$1,000 unit price and a $150 unit variable cost

CM = ($1,000 – $150) / $1,000 = .85

Isabel now knows that 85% of sales can move on to cover fixed costs or become company profits. Therefore, she can provide this information to the Retireco CEO with suggestions for how to best use this money for these purposes. By having effective financial ratios, doors open which can lead to further growth of Isabel’s career and the company as a whole. Want to check if your unit economics are sound?  Download your free guide here.

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