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Variable Costs

Value drivers are factors or variables that significantly impact the financial performance and overall value of a business or investment.

Understanding variable costs

Variable costs represent expenses that fluctuate according to the production level. Put simply, they rise with increased production and decline when production decreases. These costs encompass items such as raw material costs, wages, and energy expenses.

How to compute variable costs

Variable costs are accrued based on alterations in a business's activity or production levels. They are expenses that fluctuate in accordance with the level of activity and are also referred to as direct costs. For instance, the cost of materials used in manufacturing varies with the production level. Similarly, labor costs and other variable inputs used in production change in relation to the production level.

To calculate the variable cost for a specific level of activity, one merely multiplies the cost of the variable input by the activity level. For instance, if labor costs $10 per hour and the activity level is 100 hours, the total variable cost for labor amounts to $1,000. Should the activity level increase to 200 hours, the total variable cost for labor would escalate to $2,000.

Significance of understanding variable costs

Understanding variable costs is crucial as it aids in guiding business decisions. For instance, a business might opt to increase production if the associated variable costs for a particular product are low. Conversely, high variable costs might prompt a business to cease producing a product. Knowledge of variable costs is fundamental for making informed business choices.

Differentiating fixed costs from variable costs

A fixed cost remains constant regardless of production or output levels, while a variable cost alters according to the production or output level. For instance, a company paying a fixed rent cost of $10,000 monthly irrespective of its production volume signifies a fixed cost. On the other hand, if the company incurs $1 for each unit of product manufactured, it represents a variable cost.

Illustrating a variable costs with an example

Variable costs are those that shift based on the produced output. For example, the cost of raw materials utilized in production fluctuates according to the production level.