Variable Cost Ratio
What Is the Variable Cost Ratio?
The variable cost ratio is a calculation of the costs of expanding production in comparison to the greater revenues that will result from the increase. An estimate of the variable cost ratio allows a company to aim for the optimal balance between increased revenues and increased costs of production.
The production of goods includes both fixed costs and variable costs:
- As a rule, expanding production is a more efficient utilization of fixed costs, like the lease of a building. If creating 1,000 things costs similar fixed costs as delivering 100 things, the fixed cost per thing declines as production is increased.
- Variable costs, for example, raw materials purchases, rise with an increase in production. You can't make 1,000 gold-plated things for similar cost as 100 gold-plated things. The variable cost ratio shows when the variable costs of expanding production surpass the benefits.
Grasping Variable Cost Ratio
The Formula for the Variable Cost Ratio Is
As an alternative, the ratio can be calculated as 1 - contribution margin.
The outcome shows whether a company is achieving, or keeping up with, the helpful balance at which revenues are rising quicker than expenses.
The variable cost ratio evaluates the relationship between a company's sales and the specific costs of production associated with those revenues. It is a helpful evaluation metric for a company's management in determining fundamental break-even or least profit margins, creating gain projections, and distinguishing the optimal sales price for its products.
High Fixed Costs Mean a Lower Ratio
Companies with high fixed costs must earn a substantial amount of revenue to cover these costs and stay in business. For this type of company, it assists with having a low variable cost ratio. On the flip side, companies with low fixed costs don't need to earn a substantial amount of revenue to cover them and stay in business. This type of company can stand to operate with a higher variable cost ratio.
The variable cost calculation should be possible on a for each unit basis, for example, a $10 variable cost for one unit with a sales price of $100, giving a variable cost ratio of 0.1, or 10%. Or on the other hand, it tends to be finished by utilizing totals throughout a given time span, for example, total month to month variable costs of $1,000 with total month to month revenues of $10,000, likewise delivering a variable cost ratio of 0.1, or 10%.
Variable Costs and Fixed Costs
The variable cost ratio and its helpfulness are effortlessly seen once the essential concepts of variable costs and fixed expenses, and their relationship to revenues and general profitability, are perceived.
Variable costs are variable as in they vacillate corresponding to the level of production. Models are the costs of raw material, bundling, and delivery. These costs increase as production increases and decline when production declines.
Fixed Expenses Don't Vary with Volume
Fixed expenses are general overhead or operational costs that are fixed in the sense they remain somewhat unchanged paying little mind to levels of production. Instances of fixed expenses incorporate facility rental or mortgage costs and executive salaries. Fixed expenses just change fundamentally because of choices and activities by management.
The contribution margin is the difference, communicated as a percentage, between total sales revenue and total variable costs.
The term contribution margin alludes to the way that this number demonstrates how much revenue is left over to "contribute" toward fixed costs and possible profit.
Highlights
- The variable cost ratio shows the extra costs that are incurred in expanding production.
- A generally high ratio demonstrates a company is bound to create a gain on somewhat low sales since it has a moderately high contribution margin to apply toward its fixed costs.
- A generally low ratio shows a company is less inclined to create a gain on moderately low sales since it has a somewhat low contribution margin to apply toward its fixed costs.
