What is the variable cost ratio?
The variable cost ratio calculates the costs of increasing production compared to the more significant revenues resulting from the increase. Estimating the variable cost ratio allows a company to aim for the optimal balance between increased revenues and production costs.
Fixed costs and variable costs are associated with the manufacture of goods.
Generally speaking, boosting output is a more effective way to employ fixed expenses like building leases. If the price of making 1,000 items is the same as that of producing 100, the fixed cost per item decreases as production increases.
Purchases of raw materials are one example of a variable cost that increases as output rises. One cannot produce one thousand gold-plated items at the same price as one hundred. The variable cost ratio demonstrates that when growing output has variable costs greater than benefits,
Understanding Variable Cost Ratio
The variable cost ratio is calculated as follows: variable cost ratio = variable cost / net sales.
An alternate method of calculating the ratio is 1 (contribution margin).
The outcome shows whether or not a business is reaching or maintaining the ideal balance—that is, growing revenues faster than costs.
The variable cost ratio measures the link between a company’s sales and the production costs related to those revenues. A firm’s management may use it as a helpful assessment measure to determine the minimum or break-even profit margins required, predict profits, and choose the best sales price for its items.
Reduced Ratio Due to High Fixed Costs
Businesses with significant fixed costs must generate a sizable income to pay these expenses and stay in operation. This kind of business benefits from having a low variable cost ratio. Conversely, businesses with minimal fixed costs may continue to operate without generating significant income to pay for their expenses. Such a business can afford to run at an excellent variable cost ratio.
One way to calculate variable costs is on a per-unit basis. For example, if one unit costs $100 and the sales price is $100, the variable cost ratio would be 0.1, or 10%. Alternatively, totals for a specified period may be used; for example, if total monthly revenues are $10,000 and total monthly variable expenses are $1,000, the variable cost ratio is 0.1, or 10%.
Fixed Costs and Variable Costs
Once one understands the fundamentals of variable costs and fixed expenditures and how they relate to revenues and overall profitability, one can readily see the value of the variable cost ratio.
The way that variable costs change depending on the output volume is what makes them unstable. The price of raw materials, packing, and shipping are a few examples. These expenses rise with rising output and fall with falling production.
Fixed Outlays: Don’t Adjust for Volume
General overhead, or operating costs, are considered fixed expenditures since they don’t vary much depending on output levels. Two examples of fixed expenditures are executive pay and the cost of leasing a space. Only management choices and actions cause fixed expenditures to vary noticeably.
The contribution margin is the percentage difference between total sales revenue and variable expenses.
The fact that this figure shows how much money is left over to “contribute” toward fixed expenses and possible profit is known as the contribution margin.
Conclusion
- The variable cost ratio shows the extra expenses incurred when production is increased.
- Because it has a relatively large contribution margin to apply toward its fixed expenses, a firm with a relatively high ratio is likelier to profit on relatively low sales.
- Because it has a relatively small contribution margin to apply toward its fixed expenses, a firm with a relatively low ratio is less likely to turn a profit on relatively low sales.
