Variable Cost Ratio
The variable cost ratio is an expression of a company's
variable production costs as a percentage of sales, calculated as variablecosts divided by total revenues. It compares costs that change with levels of
production to the amount of revenues generated by production. This contrasts
with fixed costs that remain constant regardless of production levels.
Consideration of the variable cost ratio, which can
alternately be calculated as 1 - contribution margin ratio, is one factor in
determining profitability, since it indicates if a company is achieving, or
maintaining, the desirable balance where revenues are rising faster than
expenses.
The variable cost ratio quantifies the relationship between
revenues and the specific costs of production associated with the revenues. It
is a useful evaluation metric for a company's management in determining
necessary minimum profit margins, making profit projections and in identifying
the optimal sales price for a product as part of price setting. The variable
cost calculation can be done on a per-unit basis, such as a $10 variable cost
for one unit with a sales price of $100 giving a variable cost ratio of 0.1 or
10%, or by using totals over a given time period, such as total monthly
variable costs of $1,000 with total monthly revenues of $10,000 also rendering
a variable cost ratio of 0.1 or 10%.
Variable Costs, Fixed Expenses, Revenues, Contribution
Margin and Profits
The variable cost ratio and its usefulness are easily
understood once the basic concepts of variable costs, fixed expenses, and their
relationship to revenues and general profitability is grasped.
The two expenses that must be known to calculate total
production costs and determine profit margin are variable costs and fixed
costs, also referred to as fixed expenses.
Variable costs are variable in the sense they fluctuate in
relation to the level of production, or output. Examples of variable costs
include the costs of raw material and packaging. These costs increase as
production increases and decline when production declines. It should also be
noted that increases or decreases in variable costs occur without any direct
intervention or action on the part of management. Variable costs commonly
increase at a fairly constant rate in proportion to increases in expenditures
on raw materials and/or labor.
Fixed expenses are general overhead or operational costs
that are "fixed" in the sense they remain relatively unchanged
regardless of levels of production. Examples of fixed expenses include facility
rental or mortgage costs and executive salaries. Fixed expenses only change
significantly as a result of decisions and actions by management.
The contribution margin is the difference, expressed as a
percentage, between total sales revenue and total variable costs. Contribution
margin refers to the fact this figure delineates what amount of revenue is left
over to "contribute" toward fixed costs and potential profit. The
contribution margin ratio is always the inverse of the variable cost ratio.
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