Variable Costs in a Business: Everything You Need to Know
Variable costs in a business are expenses that can grow or shrink based on the production volume of the business.3 min read
2. Creating a Business Budget
Variable costs in a business are expenses that can grow or shrink based on the production volume of the business.
What Are Variable Costs?
In a corporation, variable costs are costs that can change depending on the performance of the business. For example, if the company's production increases, the variable costs will rise, and when there is a slowdown in production, the variable costs will fall.
The expenses of a business are made up of both fixed and variable costs. Fixed costs, as you can probably imagine, are expenses that are not influenced by the business's production. Whether the business is profitable or not, it is required to cover its fixed costs.
Businesses can have a wide variety of fixed costs:
- Rent for office and production space.
- Salaries of employees.
- Insurance for the business.
- Supplies for the office.
Although it is possible for fixed costs to change, this change will not be related to the production of the business. On the other hand, variable costs are solely influenced by the company's level of production. The more products the business manufactures, the higher the variable costs of production will be. If the business produces fewer products, the variable costs will lower.
Like fixed costs, there can be different types of variable costs in a business:
- Cost of labor.
- Material costs needed for production.
- Sales commissions for employees.
- Costs for utilities.
Imagine, for example, that you operate a cake company and that it costs you $5 for the cake ingredients and $5 to bake the cake. The more cakes your company produces, the more you will pay for ingredients and labor.
A company's total costs are made up of its fixed and variable costs. To determine the profits of a company, you would subtract the number of sales from the total costs.
If a company finds that it needs to increase its profits, the best solution is to reduce its total costs. Fixed costs, because they are a necessary part of running the business, are hard to reduce. This means most businesses will try to curtail their variable costs to increase profits.
Let's stay with the cake example to demonstrate how a company can reduce variable costs. If it costs you $10 total to produce a cake, and you're selling them for $15, your gross profit per cake would be $5. To increase this profit, you would either need to lower the costs of your cake ingredients or the cost to bake the cake. Net profits – what the business actually earns – are calculated by taking the gross profits and subtracting the fixed costs.
Businesses lose money when their gross profits are less than their fixed costs. For example, if the gross profits of your cake company are $500 and your fixed costs are $700, you would lose $200 in sales.
A business could reduce its variable costs several ways. It could, for example, reduce the money it spends on advertising, seek less expensive raw materials, or cut direct labor costs. It's important, however, that the quality of the business's goods or service not be damaged by reducing variable costs.
Creating a Business Budget
If a business wants to make sure its fixed and variable costs aren't too high, a strong business budget is a necessity.
Basically, a business budget is two financial statements combined into one. One budget would reflect what you would like the finances of your business to look like in a given month, and another budget would reflect the actual finances of your business.
Every budget used by a business will be broken down into two parts. The first part is revenue or income, which is the amount of money earned by your business or the money you expect to earn. The second part of your business budget is expenses. Your expenses are the most important part of your budget, as you have the ability to control your expenses.
When creating your budget, it's vital that you include fixed and variable costs and that you keep track of both in separate categories. Your fixed expenses will need to be paid every single month, and while they can change, they usually cannot be eliminated, as they are essential to running your business.
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