Variable Cost Ratio
The percentage of costs that change in direct relation to the level of production activity.
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:
- Fixed expenses are general costs that remain fixed, meaning they don't change according to the production level, such as overhead or operational costs.
- Executive salaries and mortgage or rental costs are examples of fixed costs. Sometimes fixed costs also change depending on actions taken by management or higher authority.
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.
Solution
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
Free Resources
To continue learning and advancing your career, check out these additional helpful WSO resources:
or Want to Sign up with your social account?