Variable Cost Ratio

The percentage of costs that change in direct relation to the level of production activity.

Author: Christy Grimste
Christy Grimste
Christy Grimste
Real Estate | Investment Property Sales

Christy currently works as a senior associate for EdR Trust, a publicly traded multi-family REIT. Prior to joining EdR Trust, Christy works for CBRE in investment property sales. Before completing her MBA and breaking into finance, Christy founded and education startup in which she actively pursued for seven years and works as an internal auditor for the U.S. Department of State and CIA.

Christy has a Bachelor of Arts from the University of Maryland and a Master of Business Administrations from the University of London.

Reviewed By: Osman Ahmed
Osman Ahmed
Osman Ahmed
Investment Banking | Private Equity

Osman started his career as an investment banking analyst at Thomas Weisel Partners where he spent just over two years before moving into a growth equity investing role at Scale Venture Partners, focused on technology. He's currently a VP at KCK Group, the private equity arm of a middle eastern family office. Osman has a generalist industry focus on lower middle market growth equity and buyout transactions.

Osman holds a Bachelor of Science in Computer Science from the University of Southern California and a Master of Business Administration with concentrations in Finance, Entrepreneurship, and Economics from the University of Chicago Booth School of Business.

Last Updated:February 13, 2024

What Is the Variable Cost Ratio?

The variable cost ratio is a measure used by businesses to understand how their costs change in relation with the level of production. It shows the percentage of costs that go up or down when production increases or decreases.

A high variable cost ratio implies that a significant portion of the company's costs are variable, meaning they adjust proportionally with production levels. This can be advantageous during periods of low sales, as the company can still cover its fixed costs and potentially generate profits.

Conversely, a low variable cost ratio suggests a larger portion of fixed costs within the cost structure. While this may offer stability, it can also pose challenges in generating profits during downturns in sales.

Having a high variable cost ratio gives a company more flexibility to adjust to changes in the market. But if the variable cost ratio is low, it means the company is more stable and less affected by changes in sales.

Key Takeaways

  • Variable cost ratio represents the percentage of costs that vary directly with production activity levels, crucial for understanding cost structures.
  • Variable costs fluctuate with production levels, unlike fixed costs (FC), which remain constant.
  • Contribution Margin (CM), the difference between total sales revenue and total VC, plays a crucial role in understanding revenue left to cover profits and fixed costs.
  • Variable cost ratio is instrumental in evaluating a company's break-even point, determining when revenue equals production costs.

How to Calculate the Variable Cost Ratio

We will now talk about the formula:

Variable Cost Ratio = Variable Costs (VC) / Net Sales (NS)

Another formula is

Variable Cost Ratio = 1- Contribution Margin (CM)

The total contribution margin is calculated by subtracting the value of the company's VC of total produced goods from the total sales revenue. To calculate a per-unit contribution margin, subtract the VC per unit from the selling price per unit.

Here are a couple of examples: 

  • Suppose there is a product with VC of $20 per unit and NS is $200 per unit. So, as a result, the variable cost ratio is 0.1 or 10%. CM is often used to calculate the value of VC. It is also presented in the form of percentages as well.
  • Let's say there is a company that produces bags and sells them at $100 each. The VC of the bags is $10. To get the variable cost ratio, we simply divide sales by VC, which means ($10/ $100) = 0.1 or 10%. So, we can say that the variable ratio is 10% in this situation. 

The ratio is not a very complex topic. It is not even very hard to calculate. However, it is a very important topic indeed. It indicates if a business can achieve its desirable revenue or rise in revenue before it faces any expenses. 

Significance of Variable Cost

The usefulness and importance of the variable cost are well understood when we understand the basic relationship and concepts of VC and sales, and their revenue is well understood.

VCs are variable and inconsistent as they change and fluctuate depending on the production level. Therefore, if we want to learn more about VC, we have to learn some facts about the difference and relationship between VC and FC, which is fixed cost:

Contribution margin is a very important topic too. We have to learn a little about contribution margin(CM) in learning more about the variable cost ratio:

  • CM is the difference between total sales revenue and total VC, variable costs. 
  • It is presented as a percentage. The contribution margin expresses the amount of revenue left to cover the potential profits and fixed costs. 
  • It is presented in a quantitative form which helps us to understand how it can help the company to achieve its targeted profit. It is often considered one of the most important components to guide the organization to meet its goal. That's why it is a very important and useful topic to be considered.
  • This ratio is very important as it evaluates the company's break-even point. That means it will determine at what point the company's revenue will be equal to its production cost. 
  • If a company has high variable costs due to its net sales, it might not have to cover many fixed monthly costs. 
  • This means the company will need to make a high profit to cover its fixed costs. So, that means it helps the company to survive in the market for a longer time without facing many obstacles. 

Sample Calculation

As discussed previously, calculating the ratio is simple. It is an easy formula compared to other financial formulas. A real-life example can be used to calculate and understand how it is done and what significance it has in real life. 

Now let's have an example:

  • Suppose company X sells tennis rackets. 10,000 tennis rackets are sold per annum at $200 per unit. The VC per tennis racket is $150.
  • Total revenue from squash rackets is $600,000 per year. $400,000 is spent on materials and labor. Let's work out the company's contribution margin ratio using a variable cost ratio.


VC Ratio tennis $150/$200= 75% 

VC Ratio squash $400,000/ $600,000= 67%

Since the contribution margin ratio equals 1 – variable cost ratio, the contribution margin of a tennis racket is 25%, and that of a squash racket is 33% 

Composite ratio (($10,000* $150) + $400,000) /( $10,000* $200) + $600,000)) = 73%

Composite Contribution Margin Ratio 1-73%= 27%

Thus, we can calculate the ratio very easily if we know the value of the variable costs, fixed costs, units sold, sales, etc. 

We must be careful while calculating these values to avoid errors. These formulas have served companies well for a long time.

Researched and authored by Mehnaz Tarannum | LinkedIn

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