Managing business expenses is vital for maintaining financial health and ensuring long-term profitability. A clear understanding of expenses allows businesses to make informed decisions, optimise cash flow, and plan effectively for growth.
One key category of expenses is variable expenses, which fluctuate in direct relation to factors like sales, production levels, or business activity. These costs differ from fixed expenses, which remain unchanged regardless of business performance.
In this blog, we’ll explore what variable expenses are, how they differ from fixed expenses, and why understanding them is essential for effective budgeting, forecasting, and financial management.
What are variable expenses?
In a business context, variable expenses are costs that fluctuate depending on the level of business activity or production volume. Unlike fixed expenses, which remain constant regardless of sales or operations, a company’s variable costs change in direct relation to how much it produces or sells.
For example, as sales increase, costs like raw materials, shipping fees, and commissions rise accordingly. Conversely, if production slows down or sales decline, these expenses decrease. Essentially, variable expenses are linked to the business’s output; the more a business produces or sells, the higher these costs become.
Unlike fixed expenses, variable expenses are not predictable or consistent, making them more challenging to manage but crucial for business forecasting.
Understanding how these expenses operate helps businesses plan and adjust their budgets more effectively, ensuring they can respond to changes in demand and optimise profitability.
Examples of variable expenses
A company’s variable expenses can be found across various industries, affecting both small businesses and large enterprises. Here are some common examples:
- Raw materials and supplies: For manufacturers or retailers, the cost of materials used in production or for inventory is a prime example of a variable expense. As production volumes increase, so does the need for raw materials, directly impacting costs.
- Direct labour costs (wages tied to production): Labour costs can be variable when wages are tied to the amount of work done. For example, factory workers or commission-based employees often earn wages based on production output or sales made, meaning labour costs will increase or decrease depending on business activity.
- Commissions and sales incentives: In sales-driven businesses, commissions and incentives are directly linked to the volume of sales made. As sales grow, so does the cost of commissions and bonuses paid to sales teams.
- Utility bills (electricity, gas): Utility costs, such as electricity and gas, can vary depending on business activity. For example, a factory or retail store may consume more energy during peak production periods, leading to higher utility bills.
- Shipping and delivery charges: The cost of shipping goods to customers is another variable expense. As sales increase, so does the number of shipments, driving up delivery costs. These charges can also fluctuate based on distance, weight, and shipping methods.
These variable expenses directly impact an SME's operations and profitability. While they offer flexibility, as they decrease when sales drop, they also pose a challenge in periods of growth.
Fixed and variable expenses: what’s the difference?
Fixed and variable costs behave differently. Variable expenses fluctuate based on business activity or sales volume. Fixed costs, on the other hand, remain constant regardless of sales or production. These include rent, insurance, salaries, and equipment leases, offering predictability in budgeting.
How to calculate variable expenses
Calculating variable expenses is essential for understanding how fluctuations in production or sales impact your overall expenses. Here's how to calculate and interpret variable costs:
1. Total variable cost (TVC)
A company’s total variable expenses refer to the overall costs that change with the level of production or sales. It is calculated using the following formula:
Total variable cost = Total quantity of output * Variable cost per unit of output
- Total quantity of output: The total number of units produced or sold.
- Variable cost per unit of output: The cost incurred for each unit produced, which could include raw materials, direct labour, or commissions.
Example:
If a business produces 1,000 units and the variable cost per unit is £5, the total variable cost would be:
TVC = 1,000 units * £5 = £5,000
2. Average variable cost (AVC)
The average variable cost represents the variable cost per unit of output produced. It is calculated by dividing the total variable cost by the total quantity of output.
Average variable cost = Total variable cost / Production output
This gives you the cost incurred on average for each unit produced, helping to assess production efficiency.
Example:
If the total variable cost is £5,000 and the business produces 1,000 units, the average variable cost would be:
AVC = £5,000 / 1,000 units = £5 per unit
3. Marginal cost (MC)
Marginal cost is the additional cost incurred when producing one more unit of output. For variable costs, it often aligns with the variable cost per unit.
Marginal cost = Change in total variable cost / Change in quantity of output
Example:
If producing an additional 100 units increases the total variable cost from £5,000 to £5,500, the marginal cost is:
MC = (£5,500 - £5,000) / 100 units = £5 per unit
The role of variable expenses in business decision-making
Understanding variable expenses plays a crucial role in making informed business decisions, from setting prices to cutting costs and planning investments. By tracking and forecasting these expenses, businesses can identify spending patterns and respond more effectively to changes in demand and market conditions.
1. Informing pricing strategies
Variable expenses directly impact the cost of goods sold (COGS) and, in turn, the pricing of products or services. By understanding how these costs fluctuate, businesses can set prices that maintain profitability even when expenses rise. For instance, if raw material costs increase, a business may decide to adjust product prices or find ways to reduce the cost of production without compromising quality.
Example: A manufacturer sees a rise in the cost of raw materials, such as metals. To maintain profit margins, they may increase product prices or negotiate better deals with suppliers to offset the cost increase.
2. Cost-cutting measures
When variable expenses rise unexpectedly, businesses need to find ways to reduce them to maintain financial health. Tracking variable expenses helps businesses identify areas where they can cut costs, such as negotiating supplier contracts, reducing waste, or adjusting staffing levels based on production needs.
Example: A restaurant notices that its utility bills increase significantly during busy seasons. To reduce costs, the business could invest in energy-efficient appliances or adjust operating hours to lower energy consumption during peak times.
3. Investment decisions
Understanding variable expenses is also critical when it comes to making investment decisions. If variable costs are high and unpredictable, businesses may opt to invest in technology or equipment that can lower costs in the long term. Alternatively, understanding expense patterns can guide businesses on when to scale operations or make capital investments in new opportunities.
Example: An e-commerce business with fluctuating shipping costs may decide to invest in a more efficient logistics system or negotiate bulk shipping rates with carriers to reduce per-unit delivery costs over time.
4. Forecasting and adjusting for variable expenses in financial planning
Accurate forecasting of variable expenses is essential for financial planning. By analysing historical data, businesses can predict how these expenses will fluctuate and adjust their budgets accordingly. This helps in preparing for periods of high demand or ensuring sufficient cash flow during off-peak seasons.
Example: A seasonal business, such as a landscaping service, forecasts its labour and equipment costs based on projected sales. By tracking variable expenses over time, they can adjust their monthly budget to ensure they have enough resources during peak seasons without overcommitting during slower months.
Managing and reducing variable expenses
Effectively managing variable expenses is crucial for improving profitability, maintaining financial stability, and helping businesses save money over time. Here are practical tips for SMEs to keep costs under control:
- Negotiate with suppliers: Secure better pricing by negotiating with suppliers. Consider bulk discounts, better payment terms, or exploring alternative suppliers with competitive rates.
Tip: Lock in long-term contracts or find cost-effective alternatives to reduce material costs. - Reduce waste: Minimise waste in production and service delivery to lower costs. Efficient resource use can lead to significant savings.
Tip: Implement lean practices to avoid over-ordering materials or reducing energy consumption. For instance, a restaurant can improve portion control to reduce food waste. - Optimise labour costs: Labour costs can fluctuate depending on demand. Adjust staffing levels and improve employee efficiency to optimise this variable expense.
Tip: Use a workforce management system to schedule employees based on demand, ensuring efficient labour usage during peak and off-peak periods. - Monitor expense trends: Track and analyse trends in your variable expenses to identify patterns. Regular reviews help anticipate fluctuations and make timely adjustments.
Tip: Use software like Futrli to monitor expenses in real time and set alerts for cost changes, allowing you to respond proactively. - Adjust strategies accordingly: Based on your expense analysis, adjust pricing models, supplier contracts, or production methods to control costs.
Tip: If utility costs spike during certain months, negotiate better rates or invest in energy-saving equipment to reduce future expenses.
How Futrli helps manage variable expenses
Futrli is a powerful financial tool that helps businesses efficiently track and manage variable expenses. Here’s how it can assist:
- Real-time tracking: Integrates with your financial data, providing up-to-date insights on variable expenses like raw materials, labour, and utilities.
- Budgeting & forecasting: Uses historical data to forecast future expenses, enabling better cash flow management and accurate budgeting.
- Expense categorisation & analysis: Automatically categorises expenses and offers detailed reports to help identify trends and adjust strategies.
- Seamless integration: Integrates with accounting software like Xero and QuickBooks, streamlining expense tracking and ensuring accurate financial data.
By using Futrli, businesses can take control of their variable expenses, optimise spending, and improve profitability with real-time insights and powerful forecasting tools.
Stay on top of variable expenses for business growth
For SMEs, taking control of variable expenses is a proactive step towards better financial health. By leveraging tools like Futrli, businesses can stay on top of their expenses and make data-driven decisions to drive growth.
Ready to take control of your variable expenses? Start your journey today with a 14-day free trial of Futrli and see how it can help streamline your financial management.