Variable Costs

Variable Costs

Variable costs are expenses that are directly proportional to the level of business activity such as production volume or sales — they increase or decrease as a direct result of increases or decreases in sales or production. (This should not be confused with fixed costs, which are independent of any change in business activity. Fixed costs, when combined with variable costs, yield the total costs for a business.)

For a manufacturing-based company, examples of variable costs include raw materials, packaging, and production incentive bonuses. In a retail company variable costs include sales commissions, inventory purchased for resale, and packaging. These types of expenses are called the cost of goods sold, and are always considered to be variable costs.

Depreciation is typically treated as a fixed cost, not a variable cost. The exception is when the business uses the units-of-production depreciation method, which allocates depreciation based on how much the asset is being used for production. For example, a widget-making machine may be good for 100,000 widgets. If you use the units-of-production depreciation method, the depreciation expense will be spread out based on how many widgets you make — the more you make, the more it depreciates, while the less you make, the less it depreciates. Since this ties the depreciation expense directly to the production level, this depreciation expense is a variable cost. All other depreciation methods are considered to generate fixed costs.

In some cases, costs can be partly fixed and partly variable. These are called mixed costs. For example, a factory might have a certain amount of electricity it uses for air conditioning, lighting, etc. even in the absence of any manufacturing activity. This electricity expense would be fixed. Beyond this, additional electricity is needed to run the widget manufacturing machinery as required. The busier the company, the more the widget machinery is run, and the more electricity is used. This additional electricity cost is variable. The total electricity cost is thus regarded as mixed, with both fixed and variable components.

Using fixed costs and variables costs to determine total costs is a function of cost accounting, which is a tool for management decision-making.