Definition of variable cost: an expense which increases or decreases proportionately to revenue.
What is a variable cost?
A variable cost is also known as a direct cost, because of the way it will increase or decrease in direct correlation with revenue.
This is because variable costs are the costs of goods sold, such as the materials and labour which go into each item produced.
Therefore the more items are produced and sold, the higher the variable costs will be.
Variable costs are the opposite of non-variable or indirect costs, also known as overheads. Overheads, such as rent and management costs, do not necessarily change when turnover rises or falls because they tend to be contractual, fixed amounts.
How is the phrase variable cost used in a sentence?
“Cost of goods sold is formed from variable costs such as materials and other direct expenses.”
“The income statement shows that an increase in variable costs has led to a fall in gross margin.”
What else you should know about variable costs
When companies budget for a new level of production output, they can reliably calculate future variable costs, by first calculating the variable costs per unit, and then extrapolating this over the total number of units they expect to produce.
So long as the variable cost of production remains stable (which it should if the same suppliers and production process is followed), this budgeting method is accurate.
How does the definition of variable cost relate to investing?
Variable costs are both a curse and a blessing for companies that investors have bought shares in.
With booming income, companies with a high variable cost will find that their costs will inflate in a similar proportion to revenue, which means that while gross profit will increase as an absolute £ amount, it won’t increase as a % margin.
However in recessionary periods, companies will be relieved to see that their cost base largely shrinks in line with revenue. Variability is an ideal cost behaviour to ensure minimal losses during periods of slow trade.
Therefore if you conclude that a company has a high proportion of variable costs, this may restrict upwards profit opportunities but may protect against significant losses.