As a business owner, it is important to understand the concept of expenses. Understanding the different types of variable costs and how to keep them under control can make all the difference between a company’s success and its failure.
What are Variable Expenses?
These expenses are any costs that are not fixed in nature. They typically fluctuate with changes in sales volume, production levels, overhead (indirect) expenses, and general economic conditions for an industry or area. Variable expenses are incurred at the same time that a business earns revenues. They are a necessary part of doing business.
The expenses include direct material, direct labor, freight, sales commissions, and operating expenses. Variable costs are usually incurred on an ongoing basis. For instance, if a business incurs unexpected costs for customers’ needs, such as the need to repair or upgrade equipment or hire new employees due to increased demand for its products or services, a variable expense has been created and is in effect. Variable costs include any overheads a business incurs in producing goods and services.
How to Plan For Variable Costs
Budgeting for variables can be done on a per-unit or cost of goods sold (COGS) basis. A business must calculate how much it will spend before incurring the cost. For example, how much freight costs will increase when selling additional units or products?
A business can allocate a fixed amount of money each period to accrual-based expenses, such as property taxes and insurance, based on its average usage over several periods. The amount may be based on historical expenditure. For example, the business uses about $10,000 yearly for property taxes and insurance premiums. A separate line item is added to the income statement (see chart below) to record the corresponding amount accrued on a fixed basis over an equivalent period. As the business incurs a cost in the current period, it will allocate a proportional amount of money to accrue based on that cost.
A business can also “book” an expense by recording all expenses as they occur. In this approach, a business records all expenses in the period they occur. Because all of its direct expenses are recorded, it might be easier to compare with the budgeted income for that period. Measuring variable costs is an important part of a business. This procedure aims to minimize the impact on profit by keeping the total cost of operations steady.
It is possible that the product’s design, manufacturing costs, and other factors could change weekly or monthly, resulting in month-to-month fluctuations in work-in-progress (WIP), which represents how many units are in production and awaiting sale. These fluctuations can affect profit by encouraging early shipments of products without realizing the full potential revenue from those sales.
How to Keep Variable Expenses Under Control
To prevent fluctuating percentages of costs from affecting profitability, the formula used to calculate variable costs should be adjusted by subtracting fixed costs (from the previous formula) and then dividing by the actual total units produced. This gives a more accurate picture of how much profit is being generated and how much is being spent on variables.
