Variable costs are expenses that change in direct proportion to a company’s level of production or sales volume. Unlike fixed costs (such as rent or a monthly lease payment), variable costs rise as production or sales increase and fall as production or sales decrease. Because of this direct correlation, variable costs are typically expressed on a per-unit or percentage-of-sales basis in financial models.
After revenue, I am usually doing the most research in regards to how variable costs are relevant for a particular business I'm trying to model. It is often different for every business and within a given business there can be nuances depending on the strategy / business plan.
Directly Correlated with Output
The hallmark of variable costs is that they fluctuate in tandem with production or sales levels. For instance, if you manufacture more units, the cost of raw materials goes up in roughly the same proportion.Easier to Adjust in Short Term
Variable costs can often be scaled up or down more quickly than fixed costs. This flexibility can help businesses respond to market demand and manage cash flow more effectively.Calculated on a Per-Unit or Percentage Basis
In financial models, variable costs are commonly modeled on a per-unit basis (e.g., in raw materials per unit) or as a percentage of revenue (e.g., 5% commission on each sale).Impact on Profit Margins
Since variable costs increase with each additional unit sold, they directly affect the contribution margin (price per unit minus variable cost per unit). Controlling these costs can improve profitability or allow more competitive pricing. Here is a good sensitivity table model with price / volume analysis. It will help you see what has to be true to break even.
2. Common Examples of Variable Costs
Raw Materials or Direct Materials
- Example: A bakery’s cost for flour, sugar, and eggs. Each loaf of bread will require a certain amount of raw materials, so these costs increase as more loaves are produced.
- Financial Model Perspective: Often calculated as a set amount of dollars per unit produced.
Direct Labor (Hourly or Piece Rate)
- Example: Factory workers paid by the hour or by piece-rate. As production increases, more labor hours (and thus more labor cost) are required.
- Financial Model Perspective: Often included as part of the cost of goods sold (COGS), expressed on a per-unit basis or an hourly rate multiplied by estimated hours per unit.
Sales Commissions
- Example: A sales representative might earn 5% commission on each sale. If sales volume doubles, commissions also roughly double.
- Financial Model Perspective: Modeled as a percentage of revenue (e.g., 5% × total sales).
Shipping and Freight Costs
- Example: E-commerce stores pay shipping costs per item sold. As the number of orders grows, so does the total shipping cost.
- Financial Model Perspective: Calculated on a per-order or per-item basis. Sometimes expressed as a rate dependent on weight or geography.
Transaction Fees
- Example: Payment processing fees (e.g., 2.9% + 30 cents per transaction) vary based on total sales volume.
- Financial Model Perspective: Modeled as a percentage of total sales that go through a payment processor like Stripe or PayPal.
Utilities Tied to Production
- Example: Electricity for running machinery. Although utilities can have a fixed component (basic monthly charges), the variable portion scales with production.
- Financial Model Perspective: Sometimes separated into a “semi-variable cost,” projecting a base charge plus an amount that grows with production hours or equipment runtime.
3. How Variable Costs Appear in a Financial Model
A financial model often includes detailed tabs or sections for revenue projections, cost of goods sold (COGS), operating expenses, and so on. Variable costs usually appear in the Cost of Goods Sold section when they are directly tied to producing or delivering a good or service. They may also show up under Operating Expenses if they are tied to sales commissions or other activity-based costs.
Example Structure of a Simple Financial Model
Revenue Projections
- Number of units sold Price per unit = Total Revenue
- Variable Costs (Cost of Goods Sold)
Units sold × Cost per unit (materials + direct labor) - Total Cost of Goods Sold = Sum of all variable production-related costs
- Gross Profit
- Gross Profit = Revenue − Cost of Goods Sold
- Contribution Margin per unit = Selling Price per unit − Variable Cost per unit
Operating Expenses
- May include fixed (e.g., rent) and variable (e.g., sales commissions) expenses separately.
Operating Profit (EBIT)
- Operating Profit = Gross Profit − Operating Expenses
Net Profit
- Net Profit = Operating Profit − (Taxes, Interest, and other adjustments)
4. Nuances in Modeling Variable Costs
Semi-Variable (Mixed) Costs
Some costs have both fixed and variable components. For instance, a manufacturing facility might pay a flat monthly fee for electricity (fixed) plus a usage-based rate (variable). In a financial model, you might split them into two lines to capture both fixed and variable behavior.Economies of Scale
As production grows, a company might negotiate bulk discounts for raw materials, meaning the per-unit cost decreases after hitting certain volume thresholds. Incorporating these “step-down” costs (volume discounts) can make a model more realistic.Seasonality and Demand Fluctuations
Variable costs can spike or dip based on seasonal demand. For example, a toy manufacturer might see material and labor costs surge ahead of the holiday season. Financial models can reflect this by varying unit production and corresponding variable costs each quarter.Cost Allocation Challenges
In some businesses, determining which portion of labor or overhead is purely variable can be complex. Accurate modeling may require time-tracking data or more sophisticated cost accounting techniques.Sensitivity Analysis
Because variable costs can change with production level, a sensitivity analysis often examines how profitability shifts if the cost per unit changes (e.g., if raw material prices spike). This analysis is essential for forecasting scenarios like supply chain disruptions or commodity price increases.
5. Concrete Examples in a Financial Model Setting
Example 1: SaaS Business with Commission-Based Sales Reps
- Variable Cost: Sales commissions at 10% of monthly subscriptions sold.
- Modeling Approach: Each month, the total new subscription revenue is multiplied by 0.10 to determine commission expense. If new subscriptions are forecasted to grow by 20%, commission expense also grows by 20% (assuming all else remains constant).
Example 2: E-commerce Store with Shipping and Payment Fees
- Variable Cost: Shipping cost of $5 per order + Payment processing fee of 2.9% + $0.30 per transaction.
- Modeling Approach:
- Assume 1,000 orders per month at an average order value of $50.
- Shipping: .
- Payment Processing: = $1,450, plus $0.30 per transaction = $300.
- Total variable cost for shipping and payment fees = $5,000 + $1,750 = $6,750 for that month.
Example 3: Manufacturing Company with Direct Material and Labor
- Variable Cost: $10 in materials and 15 minutes of labor (at $20/hour) per unit.
- Modeling Approach:
- Materials: $10 per unit × Units sold.
- Labor: 15 minutes = 0.25 hours. 0.25 hours × $20/hour = $5 labor cost per unit.
- Total variable cost per unit = $10 + $5 = $15. If the model forecasts 10,000 units sold, total variable production cost = $150,000.
Key Takeaways
- Definition: Variable costs move in direct proportion to production or sales volume.
- Implications: They are critical in calculating contribution margin and break-even points, influencing short-term decision-making.
- Modeling: Typically included under Cost of Goods Sold or as specific line items in operating expenses if tied to sales.
- Nuances: Consider semi-variable costs, economies of scale, and seasonality for more accurate projections.
By properly identifying and modeling variable costs, businesses can forecast how changes in production levels or sales will impact their margins. This insight is vital for pricing strategies, budgeting, and overall financial planning.
You may also find these accountings tools and templates useful.
You may also be interested in this COGS Guide for SaaS Companies.
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Article found in Accounting and Finance.
