How do you calculate variable cost per unit example?

For Go Swag, a Glasgow-based business that supplies branded employee gifts, keeping a close eye on expenses that rise and fall with production and sales – known as variable costs – is critical. Go Swag offers the option to custom-build gift bag contents and packaging, which results in hundreds of potential configurations of items, packages, and shipping destinations. This means there are lots of different potential fluctuations in variable costs every day. 

Read on to learn why tracking variable costs is so important to your business, and all you need to know to do so. 

What is a variable cost? 

A variable cost is any business expense that is directly correlated to your company’s production or sales. As your sales increase, variable costs will increase. If sales or production fall, then those costs will also fall. The easiest way to determine if a cost is variable, therefore, is to work out if the cost changes in line with output.   

Variable costs vs fixed costs 

Fixed costs are those costs that the business must pay regardless of how many products are made and sold. As Simon Laurie, a senior manager for outsourced business with accounting firm McBrides, puts it: "If your company makes pens, then you will have certain costs that are fixed, whether you’re making 50 pens or 50,000.”  

These fixed costs would include the cost of the machinery to make the pens, or factory rental costs.  

In contrast, if the pen manufacturer scales up production, it could expect to spend more on raw materials and sub-contracted labour. These costs are known as variable costs.  

Examples of variable costs 

The types of variable costs incurred by businesses will vary depending on the nature and industry of the business, explains Laurie. A professional services firm like a marketing agency could find its variable costs include professional fees and software licenses.  

At Go Swag, the company’s variable costs are broadly divided into three categories, says Conor McKenna, the company's founder and CEO. First, there is cost of goods – the physical cost of buying inventory, which is branded and put into gift bags. Second, the company must pay for shipping, which can include fuel surcharges and border handling fees. The third category of Go Swag's variable costs is marketing and sales spend, “which will vary depending on the vertical we’re targeting, and the varied cost of acquisition and conversion”, says McKenna.  

How to calculate variable costs 

There’s no single formula for calculating variable costs. However, in general, a company can calculate variable costs by multiplying the variable costs attributed to producing one unit of a particular product by the total number of products produced.  

The variable cost formula is:  

Variable cost = variable cost per unit x total number of units 

For example, if a company manufactures Christmas trees, the variable costs might include:   

• Raw Materials.   
• Packaging.   
• Seasonal labour.   
• Packaging and distribution.   

Using the variable cost formula, the company could work out that it costs £45 to produce a single Christmas tree, including labour, materials, packaging and distribution. If the company produces 100,000 Christmas trees each year, then the total variable cost would be 100,000 x 45, or £4.5 million.  

Understanding the variable cost formula is useful for companies like Go Swag because it helps with forecasting, says McKenna. “We can use our knowledge of variable costs to look at what happens if a supplier increases the cost of an item by 5%, or if the cost of shipping increases by 20% to a particular location,” he says. “We use Google Spreadsheets with custom calculators that constantly look at cost data to model what that means for our overall financial position.”    

Laurie explains that the value in tracking variable costs is that it allows you to see your gross profit margin, and to protect that margin in the event that variable costs change. “Businesses should be using variable costs to predict what happens to their gross profit margin if sales increase or fall by 20%, or if one of those costs increases dramatically,” he says.  

Average variable cost formula 

The average variable cost (AVC) is a way of measuring the total variable cost per unit sold. The formula for calculating average variable cost is:  

AVC = total variable cost / total output 

Businesses can use average variable costs to understand if they’re making a profit on their activities. If the price charged to the customer is above the AVC, then the business is likely to make a profit. If the price falls below the AVC, then the firm is no longer covering variable or fixed costs, and the business should stop production and simply pay fixed costs.    

Semi-variable cost formula 

A semi-variable cost is one where the cost is partly fixed, and partly variable. This might happen where you pay a set fee or have a minimum order to access a product or service, plus a variable cost element depending on how that item is used.  

The formula for semi-variable costs is:  

Semi-variable cost = fixed cost + variable cost 

For example, a bakery has a contract with a supplier to buy a minimum of 100 bags of bread flour each week, at a cost of £500. The 100 bags can be used to make 5,000 loaves. However, if the bakery needs to buy more flour to make additional loaves, each extra bag of flour will be charged at £4.  

In this case, the bakery has a fixed cost each week of £500. This cost remains the same whether the bakery makes no bread or 5,000 loaves of bread. However, if the bakery increases production to make 10,000 loaves, then they will pay the fixed cost of £500 plus an additional, variable cost of £400 for the extra flour.  

What is the variable cost ratio? 

The variable cost ratio is a way of expressing a company’s variable costs as a percentage of net sales. The higher the ratio, the more likely a company is to make a profit on relatively low sales, since it will have a higher contribution margin to apply towards its fixed costs. 

The formula for variable cost ratio is:  

Variable cost ratio = variable costs / net sales 

For example, a website company charges clients £500/hour for website design work. The company’s variable costs, including freelance labour, software licenses and marketing, is £75 per hour. In this case, the variable cost ratio is 0.15.   

Go Swag uses knowledge of its variable cost ratios to identify opportunities where reducing costs will make the biggest impact on overall profitability and cost-efficiency. For example, after Brexit, the company discovered that its policy of free worldwide shipping was an important factor in customer acquisition, but was costing the business dearly as a result of increasing fuel surcharges and shipping costs. 

“We were able to identify that it would be more cost-effective to reduce that variable cost by building a second fulfillment centre in the EU, and ship to global customers from outside the UK,” says McKenna.

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