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Glossary
Variable costs
Definition
Variable costs are expenses that change in value as a company’s operations change. The cost of doing business doesn’t always stay the same. When a business’ production increases, their variable costs also increase. When production decreases, the variable costs go down.
For example, say you’re creating and selling 5 knitted blankets a month. If demand increases and you now need to produce 50 blankets a month, the cost to do so will increase. You’ll need to hire more people to help (increase in labour costs), you’ll need to spend more on yarn or packaging (increase in materials and packaging costs), and so on.
Fixed costs, on the other hand, do not change based on production levels. Variable costs and fixed costs together make up total costs for companies.
For example, say you’re creating and selling 5 knitted blankets a month. If demand increases and you now need to produce 50 blankets a month, the cost to do so will increase. You’ll need to hire more people to help (increase in labour costs), you’ll need to spend more on yarn or packaging (increase in materials and packaging costs), and so on.
Fixed costs, on the other hand, do not change based on production levels. Variable costs and fixed costs together make up total costs for companies.
A closer look at variable costs and fixed costs
If something has a variable cost, it means the cost will change depending on other factors. A company will have to spend more on some expenses as its sales figures increase. Not all costs are variable, so to get the full picture of a company’s expenses, it is necessary to look at both variable and fixed costs.Variable costs vs fixed costs
A business' total expenses are made up of variable costs and fixed costs.What is a variable cost?
Variable costs are dynamic, which means they can increase or decrease based on a company’s operational activity.
Examples of variable costs:
- Materials
- Packaging
- Labour (employees and the work required to produce something)
- Marketing
- Running costs (such as electricity and gas)
- Delivery/shipping
- Transaction fees (when processing payments)
What is a fixed cost?
Fixed costs don’t change. They remain the same, regardless of whether a company’s operational activity increases or decreases.
Examples of fixed costs:
- Rent
- Insurance premiums
- Interest payments on loans
- Property taxes
How to calculate variable costs
To see how variable costs can apply to a business, we can calculate with some example production numbers. A variable costs formula can help you understand how operational expenses will increase based on a company’s output.
Variable cost = amount of output x cost per unit of output
This equation states that a variable cost is based on the cost per unit of activity (output) and the amount of activity (output) that occurs.
For example, let’s say a company pays $0.10 to produce one pen:
100 pens sold x $0.10 = $10 variable cost
1,000 pens sold x $0.10 = $100 variable cost
That’s a very basic example, but it helps you see how variable costs work in practice.
Something worth noting is that production costs per unit could potentially decrease as output increases. For example, a company might pay $0.10 to produce a pen when its production levels are low. However, through a deal with the factory, the company only pays $0.08 per pen if it commits to producing 10,000 pens. So, in this regard, the relationship between output and cost per unit isn’t always linear.
Why are variable costs important to understand when investing?
When you understand what a variable cost is, you should be able to make better investment decisions, as you’ll understand a key aspect of business operations. When making a trade or working on your trading strategy, it is important to get a full picture of a company’s overall expenses.
Variable costs impact a company’s growth prospects. The more a business grows, the higher certain costs will be. If these costs aren’t factored in properly, a profitable business (a company with a high gross margin) can quickly turn into a loss-making entity.
The biggest mistake new business owners can make when they start selling products or services is to assume what they’re spending in the present will remain the same going forward.
A company selling paper might be able to keep its delivery costs low when it’s just starting out by doing things in-house. For example, members of the company might deliver reams of paper to customers. This model allows the paper company to undercut its competitors because the delivery costs are much lower. The problem with this strategy is that as the paper company attracts more customers, its delivery demands will increase. Eventually, it will get to a point where it’s no longer possible for members of staff to deliver the daily orders.
When this happens, the company will need to enlist the services of a third-party courier. This comes at a cost. All of a sudden, the paper company isn’t able to undercut its competitors because it needs to cover the cost of paying a courier service. As such, delivery costs can be considered a variable cost.
Without taking variable costs into consideration, it’s easy to assume that things such as delivery expenses are fixed. This might not cause a problem in the short term, but it will become an issue as the company grows. That’s why anyone who has an interest in predicting a company’s trajectory must be able to define variable costs and know what they are in practice.
What do variable costs mean for traders and their portfolios?
The potential of a company can, at least in some ways, depend on its variable costs. Our fictional paper company is a great example of this.
Traders might see a new paper company growing at an exponential rate and see it as a great opportunity to take a long position. Indeed, it stands to reason that if a new paper company is growing at a faster rate than its competitors, its share price is likely to increase.
That’s good news for the company and good news for traders who use contracts for difference (CFDs) to take long positions. However, if you’ve not fully assessed the company’s business model and how it operates, you wouldn’t know that the owners haven’t factored in delivery expenses as a variable cost.
The business soon starts to struggle, and your trade goes from positive to negative. The lesson here is that you need to look at how a company operates before you open a trade. Moreover, you need to know what variable costs are. If you don’t take note of what variable costs mean and use this information to establish how a company operates, you could make a mistake when you’re trading shares.
You should now understand what variable costs are and why they are important in business. By including variable costs in your analysis, you can better assess a company’s business model and decide whether it’s a viable trading opportunity.