The variable expense ratio, also known as the variable cost ratio, is a method of determining how variable costs affect a company’s net earnings.
The variable expense ratio calculates a company’s variable expenses as a percentage of net sales. This is a helpful measure that can assist firms with pricing and production schedule.
Intrigued? This post will look at how to calculate the variable expense ratio, the formula, and where it is applied. Continue reading to find out why this is such an important business metric.
What is a Variable Expense?
Business expenses can be characterized as either fixed (unchangeable) or variable.
A fixed expense does not alter in relation to the other activities of a business. Rent and administrative wages are fixed costs that stay constant regardless of how much a corporation produces. So, consider a pencil factory; the cost of renting the factory facility will be constant month after month, regardless of how many pencils the company produces.
A variable expense, on the other hand, is linked to a company’s output or sales. The expense grows as the company produces more and reduces as the company produces less.
The cost of materials is a variable expense. To back to the pencil factory example, when output increases, the cost of wood and graphite will rise since producing more pencils necessitates the usage of more wood and graphite. If the factory cuts production, the cost will fall.
Commissions for sales reps or anyone else on staff who is paid on a per-productivity basis are examples of variable expenses. When sales are up, a corporation will pay its salespeople more, and when sales are down, it will pay them less.
Variable Cost Examples
- Physical Substances
- Equipment for Production
- Commissions on sales
- Wages for Employees
- Fees for Credit Cards
- Partners in Online Payment
- Costs of Packaging and Shipping
Let’s take a closer look at each.
#1. Physical Substances
These can include parts, materials, and even culinary supplies needed to complete your project.
#2. Equipment for Production
If you automate certain aspects of your product’s development, you may need to invest in additional automation equipment or software as your product line grows.
#3. Sales Commissions
The more things your organization sells, the more commission you may pay your salesmen as they earn clients.
#4. Wages for Employees
The more items you develop, the more personnel you may require, which means a larger payroll.
#5. Credit Cards Fees
As more services are provided, businesses that accept credit card payments from their customers will suffer larger transaction fees.
#6. Online Payment Partners
Apps such as PayPal generally charge businesses per transaction so that customers can check out purchases using the app. The more orders you receive, the more you’ll be charged by the app.
#7. Costs of Packaging and Shipping
You may pay to package and send your product by the unit, thus the costs may vary depending on how many pieces are despatched.
What is a Variable Expense Ratio?
A variable expense ratio is an accounting formula used to calculate expenses incurred in comparison to earnings growth. So, this approximation of variable expenses assists organizations in determining their true earnings. The corporations are also aware of the equilibrium point between earnings growth and higher manufacturing expenses.
In accounting, a variable expense ratio depicts an organization’s production expenses as a percentage of net sales. The cost, volume, and profit analysis comprise the ratio, which is critical in making business decisions. The income statement is used in the cost, volume, and profit analysis, commonly known as CVP analysis. This income statement categorizes overall costs as variable or fixed.
The variable expense ratio’s fixed expenses are utilized to calculate net income.
Contribution margin – fixed costs = net income.
Net Income Formula
Who Makes Use of the Variable Expense Ratio?
The variable expense ratio is an important metric for every company. It’s especially crucial for businesses looking to improve operational efficiency by decreasing costs. This is due to the variable expense ratio’s ability to assist firms in determining where increasing output makes sense and where it does not.
How to Calculate the Variable Expense Ratio
One minus the contribution margin is the variable cost ratio. This is the percentage difference between the total variable costs and the total sales volume. Furthermore, the variable expense ratio is calculated using a division formula that divides variable costs by net revenues.
Variable Expense Ratio = Variable Expenses / Net Sales
Variable Expense Ratio Formula
To calculate net revenue, add up the allowances, discounts, and returns deducted from total sales.
Variable cost ratio = 1 – contribution margin.
Here’s an illustration to help you understand. Assume that the total variable costs are $100 and the entire income is $1,000. You’ll obtain a variable expense ratio of 0.1 or 10%. To calculate the contribution margin, multiply 0.9, or 90 percent, by a one-variable expense ratio.
Read Also: CAPITAL MARKET LINE CML: Definition, Formula and Examples
Variable Expense Ratio Examples
The variable expense ratio can be determined for practically any time period – it can be calculated for the entire fiscal year, by quarter, or even by month or week. One can also calculate the variable expense ratio on a per-unit basis.
Assume that a sporting goods store is selling a hiking backpack for $100. (This is a high-quality backpack constructed of robust and waterproof material, with space for a sleeping roll and water bottles.) The backpack comes with a variable expense of $10.
We divide the variable cost ($10) by the sales income ($100) to calculate the variable cost ratio of the backpack. The answer is 0.1. When we double that by 100, we obtain 10%.
It is also feasible to calculate the variable expense ratio over time. Assume that the same athletic goods company also sells tennis rackets. Over the course of a month, sales total $20,000. The variable cost of those water bottles is $1,000.
We just divide the variable cost ($1,000) by the sales income ($20,000) to get the variable cost ratio for that month. The final result is 0.05, which is equal to 5%.
Simply use the formula 1 – variable cost ratio to obtain the contribution margin. The result can then be expressed as a percentage by multiplying it by 100. As a result, in the case of the hiking backpack, the contribution margin would be 90%. For the month of tennis racket sales, the contribution margin would be 95%.
Profitability Implications
So, the variable expense ratio illustrates the increasing costs that result from increased production. A high value indicates that the company will benefit from fewer sales because fixed costs are not excessive. A low figure indicates that the fixed expenses are high and that profits must be earned before the costs are covered.
Variable Costs and Fixed Costs
These are the expenses incurred in the creation of goods and services. Changes in production level have no effect on fixed expenses. So, variable expenses fluctuate in response to variations in production quantities. The rent paid for the company’s premises is an example of a fixed cost. Variable expenses can include the cost of product packaging materials or product delivery charges.
It is obvious that when a corporation raises production, it manages fixed costs such as rent in an optimal manner. This is because you will pay the same amount of rent whether you produce 1000 or 10,000 pieces of a product. However, for variable costs, you will need to purchase additional packaging materials to pack additional products. As a result, variable expenses raise the cost of production.
With more clarification, these two terms become clearer. After understanding the fundamental notions of fixed costs and variable costs, the relationship between revenue and overall profitability is grasped. Variable costs tend to rise with increased output and decline with decreased production. Fixed costs do not vary with manufacturing volume. Salaries and rent, for example, are examples of fixed expenses that do not change in response to changes in production. These costs are frequently influenced by the actions of the company’s management.
A low expense-to-income ratio
A low expense ratio is caused by high fixed expenses. This means that before the company can produce a profit, it must generate enough sales to pay its fixed costs. If variable expenses exceed net sales, the organization may have lower fixed costs. As a result, even with fewer sales, the company will stay profitable.
The margin of contribution
The contribution margin indicates whether or not an organization has reached the desired equilibrium, where revenue is growing faster than costs. The term contribution margin indicates that it never exposes the amount of income that remains to be contributed to fixed costs and the expected profit.
When a company produces only one type of product, the variable cost ratio is proportional to the total amount of sales. It can also be linked to sales per product and contribution margin. When an organization manufactures a variety of products, each product has its own contribution margin ratio.
To calculate the contribution margin for the whole number of products sold by the organization, use only the overall contribution margin as a % of total sales.
Why Is the Variable Expense Ratio Important?
The variable cost ratio is used to determine a company’s profitability. It indicates whether a corporation can reach a revenue-to-expense ratio in which revenue grows faster than expenses. The ratio assists in determining the necessary break-even point, which makes determining the best selling price and profit predictions easier.
The CM ratio relationship applies to either total sales dollars and total contribution margin dollars or per-unit sales dollars and contribution margin dollars in enterprises that produce a single product.
Each product in a company that manufactures many products has its own cm ratio. Only total contribution margin dollars as a percentage of total sales dollars are used to calculate the CM for the entire company.
When an organization’s variable costs are high as a percentage of its net sales, it suggests that there aren’t many fixed costs to cover each month. It indicates that a company must earn enough income to cover the fixed expenses of the manufacturing process, allowing the company to continue operating without making a big profit from sales. Because of the low fixed expenses associated with large ratios, a corporation can generate profits on relatively few sales.
When an organization’s variable expense ratio is low, it means that the breakeven threshold is high, because the income is required to cover a huge volume of fixed expenditures. As a result, a significant volume of sales must occur before any profit can be made.
Variable Expense Ratio FAQs
What are some examples of fixed and variable costs?
Variable expenses may include labor, commissions, and raw supplies. Fixed costs stay constant regardless of production output. Lease and rental payments, insurance, and interest payments are all examples of fixed costs.
What is the main difference between fixed and variable expenses?
In accounting, fixed costs are expenses that remain consistent over time regardless of output levels. Variable costs are expenses that vary directly and proportionally to variations in the level or volume of business activity.
What is another name for variable cost?
Variable costs are also known as unit-level costs since they change according to the number of units produced.
