I was working on some budget materials recently, when I was struck once again with how easy it is to get into trouble by ignoring the nature of cost. Whether you are a manufacturer, distributor of goods or a service company, understanding how costs affect your company is crucial to profitability. Using the wrong type of cost calculation for your business can make or break your company.
Today’s post is about variable costs. Next week we will look at semi-variable and fixed costs. The following week, we will look at some examples of how the wrong cost model can cost you. This column is based on material from my book, Project Management Accounting, published by John Wiley & Sons.
Variable costs are those that change in direct relationship to changes in the activity that triggers the cost. Variable cost affects all industries; the cost of the material needed to manufacture a nail increases in direct proportion to the number of nails that are manufactured. A grocery retailer will incur increased cost as more bottles of juice are sold. A consulting company will incur increased cost for each hour of service provided by hourly consultants. The more you do, the greater the cost.
In essence, a variable cost is a fixed amount of cost per unit produced or activity used. As the units produced or activities increase, the cost increases by the same proportion. If more nails are produced, the cost will increase by the same amount for each nail. If more juice is sold, the cost will increase by the same amount for each bottle; and if more consulting hours are delivered, the cost increases by the same amount for each hour of service.
So far so good, but variable cost can also have a twist, called a step variable. Let’s say that you are a shoe retailer. You may have to buy pairs shoes in lots of 100. It is possible that the more lots you buy, the cheaper the overall price. A single lot of 100 might be $2,500, or $25 a pair. Five lots of shoes, however, might be $10,000, or $20 a suit. The more you buy, the less cost per unit.
There can be a twist in variable costs for service companies as well. Say you are a company that produces custom websites, and you are charging for our services at an hourly rate but you pay your employees a salary. The employee’s hourly cost is the salary for the month plus benefits divided by 160. This seems to be a variable rate; the more the employee works for the client, the more cost is charged to the project.
So an employee works 50% each on two different projects. His cost is his salary plus benefits divided by 160, 40 hours per week (I know, I know! Some of you are shouting at the computer screen that nobody in that position works just 40 hours a week! I am coming to that).
What if the employee, who also bills 80 hours a month to another project, should work 20 hours overtime to the 1st project? The employee has now worked 180 hours in the month, and the actual overall cost has not changed because he is paid a salary. The new calculation would be salary plus benefits divided by 180, lowering the overall hourly cost for that resource.
If the project manager calculates the cost of the employee in the normal manner, then the project is being overcharged for the cost of the resource. In this case, we can say that the employee’s rate is variable within the relevant range. In this case the relevant range is 160 hours. Of course, if the employee works too many overtime hours, there may be no relevant range when the employee finds another job!
Next week: semi-variable and fixed costs.