The expenses that occur in businesses are classified into two types – fixed expenses and variable expenses.
Fixed expenses are those expenses that do not change when there is a change in production or sales level. Expenses like rent, insurance, payment on loans, management salaries, advertising are examples of fixed expenses. They change over a period of time.
Variable expenses are those expenses that are likely to be affected in proportion to the activities of the business. Expenses like production wages, raw materials, sales commission, shipping costs etc. are examples of variable expense.
A variable expense is considered as an important component and a management tool in calculating the total expense. Variable expenses are also called as unit level expense as they change with the number of units produced. Variable expenses tend to increase persistently in proportion to the capital and labor.
A business firm pays raw material for production. When the manufacturing increases, the raw material used will also increase thus increasing the expenditure. However, it is notable that the changes in expenditure occur with little or no interference by the management. The business firm will pay for the maintenance of the infrastructure like rental, electricity etc.
Examples of Variable expense
Depending on the type of business, the variable expense will vary. Some of the common examples of variable expense are the following:
- Product creation – amount involved in the creation of the product or to purchase inventory.
- Cash – Cash that is required for an immediate expense.
- Perishable foods, wages, raw materials, packaging, and utilities.
- The fuel for an airline is a good example of variable expense. The cost differs with the number of flights and trip duration.
Formula for calculating variable expense
The variable cost is calculated using the formula shown below:
Total Variable Cost = Total Quantity of Output * Variable Cost per Unit of Output
Importance of variable expense
Manager’s decisions are important as their decision should be aligned with the goals of the company.These goals are mostly linked to the financial aspects of the revenue and profit targets. The cost factor that is included in the decisions will have a major impact on the finances of the company. Consistent reporting of actual costs, correct estimation of the projected costs and the suitable integration of such costs in managerial decisions is a major component of the business operations that meet their targets and also the goals of the company.
Variable expense has a different impact on managerial decisions. This expense is fixed with respect to the cost per unit, but the total expense will increase with the volume of production. Basically, variable expense relates to the material costs that are used in production and the direct labor charges to make the products. Variable expense is important for the financial planning of the company. Managers will add the product of the variable expense as per unit costs and production volume to fixed costs to finalize the total production costs.
Variable Cost example
Having discussed about variable cost, let us take an example to see its impact on the overall profit. Consider a potato chips manufacturing company. Let us assume that it costs Rs. 25 to make 1 packet of potato chips weighing 250 gms. Out of Rs. 25, Rs. 15 for raw materials like potato, oil, salt etc. and Rs. 10 for the direct labor involved in making potato chips. The table below shows the way the variable costs change when the potatoes chips manufactured changes.
|1 packet (Rs)||2 packets (Rs)||4 packets (Rs)||6 packets (Rs)|
|Cost of raw materials||15||30||60||90|
|Total variable cost||25||50||100||150|
As the cost of production of the potato chips increases, the variable costs of the company are also increased. The total cost is calculated by the sum of fixed and variable costs. The company’s profit is dependent on that total cost which is calculated as:
Profit = Sales – Total Costs.
The profit of the company can be increased by decreasing the total costs. Bringing down fixed expense is a great challenge. Hence company will look at reducing the variable expense. By this, decreasing expense will lead to decreasing variable expense. If the potato chips manufacturing company sells each packet for Rs. 60, the gross profit for a packet will be Rs. 60 – Rs. 25 = Rs. 35. In order to calculate the net profit, the fixed costs will have to be subtracted from the gross profit.
A company who pursues to increase its profit by decreasing the variable expense will have to decrease the expense on changing costs for raw materials, direct labor and advertising. By reducing the variable expense, the company can increase the profit or contribution margin.
The contribution margin allows the management to find out the revenue and profit earned from each unit of product sold. The contribution margin is calculated as:
Contribution Margin = Gross Profit / Sales = (Sales – Variable Costs) / Sales
The contribution margin for the potato chips is Rs. 35 / Rs. 60 = 0.58. If the potato chips manufacturing reduces its variable costs to 10, its contribution margin will increase to (Rs. 60 – Rs. 10) / Rs 60 = 0.833. Profit increases when the contribution margin increases.
In order to manage a business, it is very important to understand the idea of variable expense as a crucial concept. Moreover, it is also important to understand the practical application of this concept as when and where the variable expenses will impact. To summarize, variable costs are measured as a direct function of production volume which increases with expansion in production and decreases with contractions in production.