Variable Cost Ratio

Variable cost ratio is "the proportion of each sales dollar that must be used to cover variable costs. The variable cost ratio can be computed using either total data or unit data" (M. M. Mowen, D. R. Hansen, D. L. Heitger 2012, p. 114).

Formulas

$Variable\ cost\ ratio={\frac {Total\ variable\ cost}{Sales}}$

or

$Variable\ cost\ ratio={\frac {Unit\ variable\ cost}{Sales}}$

(M. M. Mowen, D. R. Hansen, L. Guan 2009, p. 613).

Variable costs

Variable costs (VC) are often referred to as direct costs or main costs. Examples of variable costs could be raw materials, energy, and direct labor wages (B. Harrison, C. Smith, B. Davies 1992, p. 74) . They change with the level of production: the more products a company produces, the greater the total variable production costs. This relationship can also be expressed by a simple equation (H. B. Mayo 2012, p. 375): $VC=Per-unit\ variable\ cost\cdot Quantity=VQ$ The equation says that variable costs are the variable cost per unit multiplied by the quantity of production, with V being the variable cost of production per unit. As production levels increase, variable costs increase proportionally to production growth. At zero production, there are zero variable costs. For example, each additional production unit then adds $ 1 to the company's variable costs. Thus, with 200 production units, these costs amount to US$200, and with 1000 production units these costs increased to US$1000 (H. B. Mayo 2012, p. 375).

Fixed costs relation to the variable cost ratio and the contribution margin ratio

The total contribution margin is the income remaining after covering the total variable costs. It has to be the income that can cover fixed costs and make a profit. Fixed costs are an integral part of the concept of variable costs so here is the explanation of how the proportion of fixed cost to contribution margin affects operating income. There exist three possibilities(M. M. Mowen, D. R. Hansen, D. L. Heitger 2009, p. 121):

1. fixed cost can be equal to the contribution margin;
2. fixed cost may be less than the contribution margin;
3. fixed cost may be bigger than the contribution margin

In the first case operating income should be US$0 (the company reaches the break-even point), in the second possibility the company generates positive operating income. Finally, if the fixed cost is bigger than the contribution margin, then the company incurs an operating loss (M. M. Mowen, D. R. Hansen, D. L. Heitger 2009, p. 121).

Examples of Variable Cost Ratio

• The most common example of variable cost ratio is the cost of raw materials used in the production of a product. For example, if a company manufactures a product that requires 10 units of raw material at a cost of $2 per unit, then the variable cost ratio is 20%, which is the proportion of each dollar sales that is used to cover the cost of raw materials.
• Another example of variable cost ratio is the cost of labor for a particular product. If a company has a labor cost of $2 per hour for producing a product and the product requires 10 hours of labor, then the variable cost ratio is 20%.
• Variable costs also include marketing and advertising expenses. If a company spends $10,000 on advertising and its total sales are $100,000, then the variable cost ratio is 10%.

Advantages of Variable Cost Ratio

The variable cost ratio is an important metric for determining the profitability of a business. It has several advantages, including:

• It provides a clear, accurate picture of the proportion of each sales dollar that must be used to cover variable costs. This helps businesses create more accurate budgets, manage their cash flow more efficiently, and identify areas where costs can be reduced.
• It helps businesses identify and track the relationship between sales and variable costs. This enables them to better understand the impact of changes in sales on their overall profitability.
• It can be used to compare different products or services and identify which ones are more profitable. This allows businesses to make informed decisions about which products or services to focus their resources on.
• It can be used to compare the performance of different locations or departments, which can help businesses identify areas where cost savings can be made.

Limitations of Variable Cost Ratio

The variable cost ratio is a useful tool for measuring cost performance, but it does have its limitations. These include:

• It does not take into account fixed costs, which are costs that remain the same regardless of production volume.
• It does not account for changes in cost structure, such as when a company switches from a variable cost structure to a fixed cost structure.
• It cannot be used to predict future costs, since it is based on historical data.
• It does not take into account economies of scale, so it may not accurately reflect the cost savings that can be achieved by increasing production volume.
• It does not take into account the cost of capital, which can have a significant impact on the overall cost of a product or service.

Other approaches related to Variable Cost Ratio

There are several other approaches related to the Variable Cost Ratio. These include:

• Activity-based costing - This approach focuses on the cost of activities that drive a product or service. It considers the cost of each activity or process within the business and the cost of each product or service to determine the cost of the entire product.
• Target costing - This approach takes into account the costs of a product or service and then sets a target price that must be met in order to make a profit. The variable costs are considered in order to reach the target price.
• Cost-volume-profit analysis - This approach helps to determine the break-even point of a product or service by taking into account the variable and fixed costs associated with the product or service.

In conclusion, Variable Cost Ratio is one of the approaches used to analyze costs and to determine the profitability of products and services. Other approaches related to Variable Cost Ratio include Activity-based costing, Target costing and Cost-volume-profit analysis.

Variable Cost Ratio — recommended articles

Segment margin — Mixed cost — Differential costing — Overhead rate — Cost behavior — Absorbed costs — Cost per unit — Sales mix — Threshold productivity

References

• Harrison B., Smith C., Davies B. (1992), Introductory Economics, The Macmillan Press Ltd., London, p. 74
• Mayo H.B. (2012), Basic Finance: An Introduction to Financial Institutions, Investments and Management, South-Western Cengage Learning, Mason, p. 375
• Mowen M. M., Hansen D. R., Guan L. (2009), Cost Management: Accounting and Control, South-Western Cengage Learning, Mason, p. 613
• Mowen M. M., Hansen D. R., Heitger D. L. (2009), Cornerstones of Managerial Accounting, South-Western Cengage Learning, Mason, p. 121
• Mowen M. M., Hansen D. R., Heitger D. L. (2012), Cornerstones of Managerial Accounting, South-Western Cengage Learning, Mason, p. 114

Author: Radosław Cieślik