Variable Cost: Formula And Example Calculation - Wall Street Prep

Variable Cost Per Unit Formula

The average variable cost, or “variable cost per unit,” equals the total variable costs incurred by a company divided by the total output (i.e. the number of units produced).

Average Variable Cost Per Unit = Total Variable Costs ÷ Output

Calculating the average variation can be useful when it comes to assessing how variable costs are changing (i.e. rising or declining) as the company continues to grow, and ensures there are no inefficiencies where the VCs offset the benefit of higher output.

Variable Cost Calculation Example

Suppose that a consulting company charged 1,000 hours of services to its clientele.

If the total variable expenses incurred were $100,000, the variable cost per unit is $100.00 per hour.

• Variable Cost Per Unit = $100,000 ÷ 1,000 = $100.00

If the consulting company continues to scale and the number of clients (and hours billed) increases, the variable costs also increase — which can place downward pressure on the company’s profit margins (i.e. requiring more hiring and a more complex organizational structure).

What are Examples of Variable Costs?

The following list contains common examples of variable expenses incurred by companies.

• Direct Labor
• Direct Material Cost (e.g. Raw Material)
• Sales Commissions
• Management Bonuses
• Employee Stock-Based Compensation
• Shipping Costs

For example, in the case of an e-commerce company, the delivery, and shipping fees associated with each sale would be classified as a variable expense, while utilities would be a fixed expense.

If a higher volume of products is produced, the amount of delivery and shipping fees also incurred increases (and vice versa) — but utility costs remain constant regardless.

How Do Variable Costs Affect Operating Leverage?

The concept of operating leverage is defined as the proportion of a company’s total cost structure comprised of fixed costs.

• High Operating Leverage → Higher Proportion of Fixed Costs in Cost Structure
• Low Operating Leverage → Lower Proportion of Fixed Costs in Cost Structure

If a company has low operating leverage — i.e. a higher percentage of variable costs — then each incremental dollar of revenue can potentially generate lower profits because variable costs would offset any increases in revenue.

However, the risk associated with high operating leverage is that if customer demand and sales are lackluster, then the company is restricted in terms of potential areas for cost-cutting.

In effect, a company with low operating leverage can be at an advantage during economic downturns or periods of underperformance.

Since variable costs are tied to output, lower production volume means fewer costs are incurred, which eases the cost pressure on a company — but fixed costs must still be paid regardless.

How Do Variable Costs Impact Break Even Point?

The break-even point refers to the minimum output level in order for a company’s sales to be equal to its total costs.

Break-Even Point = Fixed Costs ÷ Contribution Margin

Suppose a company’s cost structure consists of mostly variable costs — in that case, the inflection point at which a company starts to turn a profit is lower (i.e. compared to those with higher fixed costs).

The higher the percentage of fixed costs, the higher the bar for minimum revenue before the company can meet its break-even point.

High operating leverage can benefit companies since more profits are obtained from each incremental dollar of revenue generated beyond the break-even point.

However, below the break-even point, such companies are more limited in their ability to cut costs (since fixed costs generally cannot be cut easily).