Lowering your variable costs is one of the most common, effective ways to increase your profit margin and make more money per sale. That’s good news if your business is really starting to pick up, but you’re still finding it difficult to pay the bills.
First, a definition of variable costs. Then we’ll dive into the differences between variable and fixed costs, examples of each, and how calculating variable costs can help you earn more.
What is a variable cost?
A variable cost is the price of raw materials, labor, and distribution associated with each unit of product or service you sell. That unit could be a Warren Buffet bobblehead or an hour of aromatherapy counselling. Whatever you pay to create each unit falls under the heading of “variable cost.”
Your variable cost varies with your production volume—the more you produce, the more you pay, and vice versa. Maybe that sounds like a perfect circle-of-life style balance between expenses and profit: Pay X to create product, sell it for twice that price, make a profit. Simple, right?
Unfortunately, it’s not. And that’s thanks to variable cost’s evil twin, fixed costs.
Variable costs and fixed costs
The definition of a fixed cost is any expense you have to pay that doesn’t vary according to how much of your product or service you produce. Added up, your fixed costs are the price of staying in business—no matter how much business your business is doing. Another name for this is overhead.
Fixed expenses stay the same month to month. That makes them predictable: If your fixed expenses add up to $1,000 each month, you know you’ll need to make at least that much money to stay in business.
That predictability comes with side effects, though. Fixed costs tend to be rigid and hard to change—like rent, or the price of insurance. So, when it’s time to cut costs and increase your profit margins, fixed expenses are the most difficult ones to tackle. Variable expenses, on the other hand, tend to be more flexible. Typically, variable costs are the first thing to get cut when companies want to increase profit margin.
If the differences between the two still seem unclear, you should get a better sense of them with the examples of fixed vs. variable expenses below.
Examples of variable costs and fixed costs
If you’re ready to start reducing either variable or fixed costs for your business, it’s helpful to know which expenses fall into which categories. Here’s a list of fixed vs. variable expenses:
Fixed vs. Variable Expenses Examples
|Fixed Expenses||Variable Expenses|
|Rent||Cost of raw materials|
|Property expenses (taxes, upkeep)||Distribution costs (shipping, restocking)|
|Depreciation||Utilities (tied to production)|
|Business insurance||Credit card transaction fees|
|Social media||Per-piece labor and hourly wages|
|Utilities (not tied to production)|
Most businesses will have more fixed costs than variable costs. Naturally, whether you spend more on fixed or variable costs depends on how many sales you make.
Some expenses cost a certain minimum amount each month (like a fixed cost), then increase with the number of sales you make (like a variable cost). Some examples:
Utilities in production facilities. It costs a certain amount to keep the lights on every month, but the electricity bill goes up the more your machines produce units.
Work vehicle expenses. You’ll have to pay insurance for your delivery vans regardless of whether they make deliveries. Once they do, gas bills get added on, and this expense increases.
Employee overtime. If your employees have the option to work overtime, the cost of labor starts to increase. For instance, the line cook in your café works eight hours per day minimum. On really busy days, she has to stay late to clean and prep in the kitchen; your labor expense grows in sync with sales volume.
Bookkeeping and accounting. Bookkeepers and accountants typically charge a monthly minimum for their services. But more business transactions (sales) means more work for them—so their cost goes up. (For example, Bench charges a flat monthly fee for bookkeeping, based on your rough number of expenses.)
Semi-variable costs fall somewhere between fixed and variable. Likewise the ease of reducing them: No matter how much you cut back on the part of a variable expense tied to production volume, you’ll still have to pay a monthly minimum. However, you still have more wiggle room than you do with fixed expenses. So, once you’ve cut back variable costs as much as possible, it makes sense to move on to semi-variable.
Calculating variable costs
To figure out variable costs for your product, you’ll need to do a little math.
For instance, let’s say you make and sell hand-painted “World’s Best Boss” mugs. Each blank mug costs you $2.00 wholesale. That’s an easy expense to calculate.
But what about the cost of paint? You calculate that each can of paint is enough to create 40 mugs. And, conveniently, paint costs $40 per can. So, dividing 40 by 40, you can see that you pay $1.00 per mug for paint.
Now, consider labor. Your average professional mug-painter makes $15 an hour. And on average they can paint three mugs each hour. So the labor cost for each mug is $5.
Proceeding like this, you can calculate the variable cost per unit.
Calculating variable cost per unit
To calculate the variable cost of each item you sell, add up every expense directly related to creating it—the variable cost per unit.
Cost of plain mug: $2.00 Cost of paint: $1.00 Labor: $5.00 Shipping: $6.00 Total: $14.00
Each mug costs you $14 to produce and send to a customer. You should use that info to determine how much you charge customers per mug. (You may or may not want to include shipping in your calculation, depending on whether postage is included with the price the customer pays.)
Calculating profit margin with variable costs
Here’s the formula for finding your profit margin on each unit produced:
Retail price per unit – Variable cost per unit = Profit margin
Simple example: Say you sell your mugs for $24 each, shipping included. We know that each mug costs $14 to make. Once we plug those numbers into the equation, we see that you earn $10 per mug sold.
Variable costs and breaking even
So, you’re taking variable cost per unit into account, you’re making $10 per mug. Not bad—but you still have fixed expenses to pay.
Remember, you need to pay fixed costs every month in order to stay in business, or “break even.” Your break even volume is the number of units you must sell every month in order to pay your fixed costs.
Here’s the break even volume formula:
Fixed costs / Revenue per unit after variable costs = Break even volume
Let’s say that fixed costs for the mug store—rent, utilities, ecommerce site—is $1,100 per month. And your revenue per unit sold is $10.
1,100 / 10 = 110
So, you’ll need to sell 110 mugs to break even.
You can also plug the numbers into a table to find out how much net income you’ll make per month depending on how many units you sell.
|Units sold||Total sales||Total variable cost||Total fixed cost||Net income|
(Totals in brackets indicate a negative number.)
How to reduce variable costs
The steps you take to lower your variable cost per unit and increase your profit margin will depend on what kind of business you run.
For instance, for the mug business, you could lower variable costs by training your employees so they paint more mugs per hour, finding a less expensive wholesaler of blank mugs, or using a less expensive paint.
Your goal should be to reduce the cost of producing each item, while maintaining the same level of quality. If half the World’s Best Boss mugs you sell leave the apostrophe out of “World’s” (because your employees are rushed), and all of them disintegrate after three cycles in the dishwasher (because you switched to using cheaper mugs), then you’ll start to lose business. And that can considerably offset any money you save by cutting costs.
Here are some common ways to reduce variable expenses for your business:
|Method for reducing variable expenses||Examples|
|Spend less on raw materials||-Find vendors with lower prices
-Buy in bulk
-Form a buying group with other businesses to save
-Form a joint venture with a manufacturer
|Spend less on labor||-Replace employees with contract labor
-Train employees to be more efficient
-Offer bonuses to create incentives for efficiency
|Save on card transaction fees||-Stop accepting credit cards
-Switch to a different credit card processor (eg. Square)
|Reduce the cost of distribution||
-Find alternative shipping services
-Reduce packaging (weight)
-Use online shipping services
-Switch to an order fulfillment service
If you’re having trouble seeing how these techniques could apply to your business, consider hiring a business operations or managerial accounting consultant with experience in your industry. They may be able to find loopholes, shortcuts, and tricks of the trade that can help you reduce your variable costs. In that case, the cost of hiring them will pay off in the long run.
Once you’ve done everything you can to tighten up variable costs for your business, there are other ways to lower the cost of doing business. It’s time to look at your overhead.