The most common error made by business owners is to use this term in financial accounting. I don’t recommend using variable costs in financial accounting unless you qualify its usage. You should have a true in-depth understanding of related terms such as fixed costs, sunk costs, mixed costs, depreciation, overhead accumulation and the associated overhead allocation. For those of you that are novices or intermediate level business owners, it would be best to stick to using the term with cost accounting until you gain the appropriate knowledge.
This article is a basic introduction to the term. I will provide the technical definition and appropriate application. In addition, I’ll provide two simple examples of its use leading up to a more comprehensive example. Finally, I’ll touch base and introduce the reader to its complexity when used with financial accounting so that you can appreciate limiting its use to cost accounting.
Technical Definition and Application
Back in college, my cost accounting course defined variable costs as those expenditures that changed in direct proportion to the change in production. If production increases, those costs that increase with production are variable in nature, i.e. linked to the change in production. As a continuation of this concept, if production decreased, then those costs that decreased with this change are also variable. The best examples are raw materials and labor. Assuming labor is on demand, if the production run is ramped up then the raw materials, labor, energy, packaging and distribution related costs would increase too. However, some costs will not change such as rent for the warehouse or the lease payment for the production equipment.
Those costs that have no change related to production within a relevant range are considered fixed costs. To fully appreciate variable costs, please read my article about fixed costs. Earlier I stated that variable cost is a cost accounting term. It is used to identify the overall production cost related to a change in volume. All of us in the business world generally associate any increase in production or sales as good thing. After all, that is one of reasons we are business, to make more money. However, in cost accounting the goal is to identify issues that cause a non-linear increase or decrease in costs. Again, if volume increases you would think the average cost per unit would decrease. But often this is not true. Sometimes there is a significant increase in the variable costs of production related to either the increase in raw materials or labor. A good example is receiving your raw materials via the transportation medium (trucking, rail or direct delivery) but if you increase the demand beyond the capacity of the delivery mechanism then a second deliver system must be used. Often the second medium is more expensive than the first or marginally more expensive.
Assume your raw materials are delivered via a tractor trailer. The trailer can hold 28 pallets of your raw material; the 29th pallet requires another tractor trailer load to deliver. The delivery fee is constant because the trucking company charges a flat rate for up to 28 pallets. After that it is the same delivery fee for the 29th pallet due to requiring a second tractor trailer load. Therefore, the average cost per pallet of raw material goes up with the 29th pallet due to the use of a second delivery truck. Therefore the change in cost per unit for that production run actually increases per unit and therefore the economy of scale we sought isn’t necessarily there. In effect the relevant range is up to 28 pallets and the average cost per pallet decreases as you head toward the 28th pallet, but on the 29th pallet, it jumps significantly per pallet and continues to decrease on average through the 56th pallet (the maximum number of pallets for two trailer loads).
The goal of cost accounting is to identify the cost drivers of production. Variable costs are some of the types of costs in production. By understanding the variable costs, the accountant can then identify the breakeven points for production runs and help the company determine the profitability of manufacturing or rendering service. If the owner of the company knows his fixed costs and the variable costs, he can then use this knowledge to understand how many units he must sell to breakeven or earn a required level of margin or even profit.
Let’s use this concept of understanding cost accounting and the variable costs and find out how many widgets we must produce to cover fixed costs. Unlike in example ‘A’, the variable cost is indeed linear in nature to production. That is, it remains constant per unit no matter how many units we produce.
Let’s assume our production widget is toilet paper. It costs us around 23 cents per roll to produce. This 23 cents covers the raw materials, the hard cardboard roll, the labor for production, the packaging materials, palletizing costs and the costs to load the pallets onto a truck for delivery. Our fixed costs are the costs of manufacturing equipment leases, rent, insurance, safety equipment, and warehousing costs. Altogether, it costs the company $21,000 per month for these fixed costs. Remember, we pay these fixed costs even if we don’t produce a single roll of toilet paper. We sell each roll for 32 cents.
For some strange reason, no matter how many rolls we produce, the market buys them. In addition, our production line allows us to produce up to 1 million rolls (1,000,000) per month without requiring more equipment. Based on this information, how many rolls do we need to produce to cover our fixed costs of $21,000? Let’s assume overhead costs are $35,000, and we would like to have a profit of $18,000 per month to cover our compensation and risk of capital. OK, let’s begin.
Step 1 – determine the number of rolls we need to produce to cover fixed costs. This is a simple algebra equation (remember when we told our parents we would never need algebra in the real world?) of having a known and a variable to calculate the unknown. Therefore: Fixed Costs = (.32 – .23)X, we use the profit per roll of 9 cents to calculate the number X of rolls of toilet paper we need to produce; therefore
$21,000 = .09X; to solve for X, we divide by .09 on both sides of the equation
$21,000/.09 = X; solve the equation
Therefore, we need to produce 233,333 rolls of toilet paper to get enough cash from the sale of this production run to cover our fixed costs of production.
Step 2 – determine the number of rolls we need to produce to cover fixed costs and overhead costs. Again, as in Step 1, we just need to add the overhead costs to fixed costs to get the total costs we need to cover.
Fixed and Overhead Costs = (.32 – .23)X, X is the number of rolls of toilet paper needed from production
$21,000 + $35,000 = .09X
$56,000/.09 = .09X/.09
$56,000/.09 = X
Therefore, we need to produce 622,222 rolls of toilet paper this month to cover fixed and overhead costs.
Step 3 – determine the number of rolls of toilet paper production required to cover fixed, overhead costs and a profit of $18,000. Just like step 2, we add the costs together.
$74,000 ($21,000 + $35,000 + $18,000) = .09X
Therefore we need to produce 822,000 rolls of toilet paper to achieve the profit desired.
From this information, can we determine the maximum profit if we produce all one million rolls in a month? The answer is yes, the contribution dollar per unit is 9 cents. With 1 million rolls produce, we earn a total of $90,000 (1,000,000 * .09 each). If we subtract fixed and overhead costs of $56,000 it leaves us with a profit of $34,000. $34,000 is our maximum profit given our production run and associated costs (variable, fixed, overhead).
Now you see how variable cost is used in cost accounting to help management make decisions. From the above example, management can explore other issues or variables to help maximize profitability. A good example is adding some more fixed costs and reducing variable costs and recalculate to see if we could earn more profit.
Same as in the toilet paper manufacturing except we want to lease an automatic palletizer (a system eliminating the labor associated with stacking the cases onto a pallet). The palletizer costs an additional $900 per month for the lease but saves us .0021 cents per unit in labor costs. If our new contribution margin increase (variable costs decreased) covers the additional fixed costs of $900, then it would be a wise decision to replace the labor with a machine. Let’s find out:
Assuming a production run of 1 million units, how much more contribution are we getting? Answer: .0021 times 1 million units. If this answer exceeds $900, then any amount over $900 is that much more profit we will make per month. Thus, .0021 times a million is $2,100 and the fixed costs increase is $900, therefore we will increase our profit by $1,300 per month. It would be a wise idea to increase our fixed costs by $900 per month assuming we can sell all one million units of production.
But suppose that we can only sell as a guarantee, 650,000 units per month. Would it be wise to make the change? Answer: .0021 times 650,000 equals $1,365 more contribution margin which easily covers the additional $900 of costs. Still a good decision at this level of production.
Now you get an understanding of the application of variable costs in cost accounting. Remember I stated above that variable cost is used in cost accounting and only those that have a true understanding of the relationship with other costs accounting terms can understand the use of the term with financial accounting.
Using Variable Costs in Financial Accounting
Financial accounting is more complex than cost accounting as financial accounting reports the outcome after the fact. That is, financial accounting records the economic activity over a period of time. It reports this volume of activity and then illustrates the change in financial position during this time period. Cost accounting is used to make production decisions whereas financial accounting is a record of the financial outcomes from those production decisions. The scope of activity is broader in financial accounting as it incorporates all the general and administrative costs including human resources, marketing, management, legal and compliance costs. Cost accounting restricts itself to production costs and for the most part excludes the general and administrative costs. Advanced cost accounting can use overhead pooling and allocation formulas to include these respective expenses.
The problem is that variable cost is frequently used by the novice or less informed businessmen in discussing or explaining financial information. The most common mistake is equating the costs of goods sold as variable costs in a company’s financial reports. This may appear correct as they seem similar. Remember, variable costs change with production. Well, costs of goods sold change with the volume of sales. Why are they not the same thing? Answer: Cost of Goods Sold is a function of sales and the difference equates to gross margin. Gross margin is used to cover fixed and operational costs. In production, variable costs are used to determine the contribution margin per unit which then is used to identify the level of production needed to cover the fixed costs. In cost accounting, we assume we can sell the entire production run. This is not true in financial accounting.
In addition, cost of goods sold can include some costs not normally equated to variable costs with production. These costs relate to various non-production related issues and include:
- Human Error – with purchasing; failing to order materials in a timely manner necessitating additional fees to maintain proper delivery and timing of raw resources
- Early Pay Discounts – some industries include early pay discounts in the costs of materials or supplies and therefore in costs of goods sold whereas this value is not included in cost accounting
- Labor Benefit Costs – there is often a significant difference in dollars between the amounts used in calculating labor costs for cost accounting and those assigned to cost of goods sold
But the most likely difference between the two types of accounting for variances relates to product mix sold in the market. With cost accounting, it is designed for a single production run of a particular product; using our example above, simple single ply toilet paper. But in reality, cost of goods sold relates to a multitude of products sold and the costs associated with those different pools of items. If we continue using toilet paper as the example, the financial statement will report the sales and costs of goods sold related to:
- Single Ply
- Two Ply
- Two Ply Cotton Soft
- Two Ply Extra Soft
- Two Ply w/Aloe
You get the idea.
My point is that variable costs are not equal to costs of goods sold. Variable costs are cost accounting issues and cost of goods sold is a financial accounting matter.
Summary – Variable Costs
Variable cost is synonymous with one of the types of accounting known as ‘Cost Accounting’. It is frequently used in financial accounting by novice businessmen that mistakenly apply variable costs as a concept of accounting in general. Variable costs are those costs that change in relation to production whether up or down. You may use the term in financial accounting but please be aware of its limitations and gain an understanding of the related terms such as fixed, mixed, sunk and overhead costs. Act on Knowledge.