What Is a Variable Expense?

Variable expenses refer to costs that fluctuate in accordance with the company’s production. In simple words, the variable expenses increase as the production level rises. Additionally, it decreases with production levels. Material cost, sales commissions, packaging supplies, and labor costs fall into the variable expenses category.

For instance, the requirement of wood as a raw material in a wooden utensils manufacturing company will depend on the demand & production of utensils. Thus, the cost of wood as a raw material will be a variable cost or variable expense.

In contrast, fixed costs such as rent, loan repayment amounts, and employees’ monthly wages remain constant, regardless of the production level.

How Do We Calculate Variable Costs?

So, we have defined the answer to the question – what is a variable expense? Now, we proceed with its calculation. Mind it, this process is indeed crucial. This is because, without the variable cost value, it is impossible to predict the variable expense ratio.

If you know the fixed cost value, then you can find out the variable cost straightforwardly as:

Variable Cost = Total Cost – Total Fixed Cost

Alternatively, you can also find the variable cost by using the following formula:

Variable Cost = Variable Cost of Each Output Unit x Total Output Quantity

Here,

Variable Cost of Each Output Unit – It is the total sum of all variable costs needed to produce one unit. (material cost + labor cost + other applicable cost)

Total Output Quantity – Total number of units (product) produced.

Moreover, you can find the variable cost per unit, also known as the average variable cost. This helps to understand and perform profit margin calculations, break-even analysis, and the setting of cost control strategies. To find out the total variable cost per unit, you need to use the following formula:

Variable Cost Per Unit = Total Variable Cost / Total Number of Units Produced

What Are Common Variable Expenses?

After understanding the variable expense meaning, we now see the common variable costs that are common in various businesses:

Raw Materials

This variable expense is related to the raw materials or direct materials that manufacturers require. It is an expenditure associated with the production of the product. The raw materials are directly related to the production level. For instance, manufacturing units will require more raw materials when the demand is high. This leads to high expenditure.

Commissions

The commission is also considered a variable expense because it varies each month based on the number of products sold. In simple terms, the salesperson will earn a higher commission for each additional sale. Thus, the commission is a type of variable expense.

Direct Labor Costs

The hourly-based wages paid to the employees also fall under the variable expense category. This is because they are proportional to the production level, which increases or decreases. When production is high, the cost increases, but it also slows down when production is low.

Shipping or Freight

Shipping costs will always vary with the production levels. The total cost will change monthly according to the number of units shipped, even when you have a set shipping price for the product.

Utility Bills

Utility bills, such as electricity bills and gas bills, vary depending on consumption. In the manufacturing industry, electricity consumption increases when production levels rise. Thus, the electricity bill comes under the variable expenses.

Packaging Supplies

The material required for the product’s packaging depends on the demand and production of the product. The requirement for such materials may be high or low, depending on the production. Therefore, the expenditure on buying such materials will be a variable expense.

Payment Processing Fees

The charges of a credit card or any other payment system are also variable expenses. This is because these charges depend on the number of transactions. If the transactions is more, the processing expenditure will be more.

What Is a Variable Expense Ratio?

A variable expense ratio is a financial metric that compares the company’s variable costs to its net sales. It is expressed in the percentage form. This ratio is useful for business professionals to understand how much of their revenue cost has been spent on variable expenses.

A low ratio indicates a high contribution margin & profitability for the business. This is because the company’s variable costs are minimal compared to its revenue consumption. Conversely, a high ratio refers to a low contribution margin.

Variable Expense Ratio Formula

The determination of the variable cost ratio solely depends on the formula explained below:

Variable Expense Ratio = Variable Cost ÷ Net Sales x 100

Here,

Variable Cost – The business cost that varies in proportion to production or sales. It includes raw materials, labor costs & commission.

Net Sales – The total revenue of the business that comes after deducting discounts & returns.

As the above ratio is expressed in percentage form, we multiply it by 100.

How to Calculate Variable Expense Ratio?

Let’s explore how to find the variable expense ratio. Initially, professionals need to identify the company’s total variable expenses and net sales for a particular period. The next move is to utilize the variable expense ratio formula to calculate the variable cost ratio.

Variable Expense Ratio = Variable Cost ÷ Net Sales x 100

One thing you need to keep in mind is that the period for total variable expenses and sales revenue will be the same.

Variable Expense Ratio Example

Let’s understand the variable expense ratio through an example. Suppose the total variable expense of your company is $3000, and the sales are $10,000; then the ratio will be as follows:

$3000/$10,000 x 100 = 30%

Thus, the variable cost ratio will be 30%.

Contribution Margin Ratio

Another crucial cost accounting metric is the contribution margin ratio, also known as the CM ratio. The ratio is obtained by subtracting variable costs from the total sales.

Contribution Margin Ratio = Sales – Variable Cost ÷ Sales x 100

10,000 – 3000 = 7000

7000/10,000 * 100 = 70%

The alternative method to calculate the CM ratio is to subtract the variable cost by 100.

The variable expense ratio was 30%. So, subtracting it from 100, we get 70%.

Factors to Consider When Calculating the Variable Expense Ratio

So far, we have defined how to find the variable expense ratio. Now, let us define the key points to consider when calculating the variable cost ratio.

Basis of Calculation (Total or Unit)

Professionals can consider total sales, unit variable costs, and total variable costs. They must enter the total for each to use the total cost and total sales revenue. On the other hand, professionals must calculate the per-unit selling price and per-unit variable cost. After that, use these values in the variable expense ratio formula.

Utilize the Consistent Time

There is the same timeframe for analysing the total company’s variable expenses and net revenue. Any variation in the period will yield an incorrect result.

Accurate Sales Data

One must always utilize the net sales to ensure an accurate ratio. Professionals should always consider the total net sales revenue. This revenue is calculated as the total sales amount minus allowances and discounts. Overstated sales can understate the actual expense ratio.

Correct Classification of Costs

Always include expenses that fall under the variable expense categories. When calculating the variable expenses ratio, it is essential to distinguish between variable expenses and fixed expenses clearly.

Calculating the Variable Expense

Variable expense calculation is highly complicated. That’s where you must be careful and consider all the factors that distinguish variable expenses from fixed expenses. For example, on your utility bill, you should be aware of the minimum fee required for your electricity bill. That comes under fixed cost and must not be accidentally considered a variable expense.

Why Is the Variable Expense Ratio Important?

The variable expense ratio is a valuable metric that companies use to make informed financial decisions. However, its value is more than that in terms of the points listed below:

Refine Profitability

Professionals can easily track their company’s profit margin, and businesses can enhance their net income. A reduction in variable cost ratio always has a positive impact on a company’s financial health.

Capital Management

A high variable expense ratio indicates overspending. It is beneficial for companies to manage their business’s operating cash flow effectively. Additionally, it helps to forecast cash flow, which is helpful in identifying areas where expenses can be reduced. Overall, this ratio plays a crucial role in ensuring that capital is utilized effectively.

Aid Financial Planning

The variable expense ratio is essential for the forecasting and budgeting process. It enables companies to accurately predict future expenses, allowing professionals to establish realistic financial goals.

Helps to Set Pricing Structure

Calculating the variable cost ratio is helpful for companies to outline the pricing structure. Business professionals can easily determine how costs align with revenue. Furthermore, they can easily get the minimum pricing point to ensure satisfactory profitability.

Variable Expenses vs Fixed Expenses – What’s the Difference?

Variable expenses and fixed costs are two primary classifications of business expenses. But what is the difference between these two terms? Here is the tabular form of comparison:

What Is an Ideal Variable Expense Ratio?

A variable expense ratio varies according to industry type and depends on the business model and the company’s financial goals. Generally, an ideal ratio leaves revenue after accounting for all variable expenses. This revenue should be enough to cover earned profit & fixed expenses.

Let us consider the industry perspective. A manufacturing company incurs high production expenses, resulting in a high variable cost ratio. On the other hand, a law firm will aim to keep its variable cost ratio low, as it incurs expenses related to high employee wages.

Additionally, market conditions and company stage also determine the variable expense ratio. Changes in the costs of labor and raw materials influence the variable cost ratio. Similarly, the company stage also has an impact on this. For example, the variable cost ratio is higher for startup companies compared to well-established enterprises.

A high variable cost indicates that the company is incurring more expenses for labor, materials, and other variable costs. A lower variable cost shows more sales requirements to cover fixed expense payments.

Final Statement

The variable expense ratio offers valuable insights to the business. That’s why business owners must monitor & manage it wisely. Knowing the variable cost per sale helps businesses gain insight into profitability, budgeting, and decision-making. Professionals can effortlessly set pricing by knowing the variable cost per sale.

Companies should strive to keep the variable cost ratio as low as possible to maintain control over their business budget. Additionally, professionals can automate their billing and expense analysis by using the right invoicing software, such as Moon Invoice. Wanna Try? Please give it a go!

Frequently Asked Questions