Variable Cost Ratio

The variable cost ratio represents the increased cost due to the increase in production. It is a calculation that shows the increase in cost due to the increase in production results in revenue.

Companies tend to make an optimal balance between increased cost of production and increased revenue.     

• Comparatively, a low ratio indicates that the company will likely make a low profit on comparatively low sales due to the relatively low contribution margin to apply towards its fixed costs. 
• Comparatively, a high ratio indicates that the company will likely make a high profit on comparatively low sales due to the relatively high contribution margin to apply towards its fixed costs.

Both fixed costs and variable costs are important for the production of goods. 

• Generally, a more efficient type of fixed cost is increased production. For example, leasing a place. When producing 500 items costs the same as producing 100 items, the production increases, and the fixed cost decreases.
• Variable cost is different from fixed cost. Suppose the price of raw materials increases; the production cost increases. For example, 200 pieces of gold-plated jewelry can't be made at the cost of 100 pieces of gold-plated jewelry.

Formula

We will now talk about the formula:

Variable Cost Ratio (VCR) = Variable Costs (VC)/ Net Sales (NS)

Another formula is VCR= 1- Contribution Margin (CM)

The total contribution margin is calculated by subtracting the value of the company's VC of total produced goods from the total sales revenue. And to calculate a per-unit contribution margin, subtract the VC per unit from the selling price per unit. 

Suppose there is a product with VC of $20 per unit and NS is $200 per unit. So, as a result, the VCR is 0.1 or 10%. CM is often used to calculate the value of VC. It is also presented in the form of percentages as well.

Let's say there is a company that produces bags and sells them at $100 each. The VC of the bags is $10. To get VCR, we simply divide sales by VC which means ($10/ $100) = 0.1 or 10%. 

So, we can say that the VCR is 10% in this situation. 

The ratio is not a very complex topic. It is not even very hard to calculate. However, it is a very important topic indeed. It indicates if a business can achieve its desirable revenue or rise in revenue before it faces any expenses. 

Significance of Variable Cost

The usefulness and importance of VCR are well understood when we understand the basic relationship and concepts of VC and sales, and their revenue is well understood.

VCs are variable and inconsistent as they change and fluctuate depending on the production level. Therefore, if we want to learn more about VC, we have to learn about the difference and relationship between VC and FC, which is fixed cost. 

Fixed expenses are general costs that remain fixed, meaning they don't change according to the production level, such as overhead or operational costs. 

Executive salaries and mortgage or rental costs are examples of fixed costs. Sometimes fixed costs also change depending on actions taken by management or higher authority. 

Contribution margin is a very important topic too. We have to learn a little about contribution margin(CM) in learning more about the variable cost ratio. CM is the difference between total sales revenue and total VC, variable costs. 

It is presented as a percentage. The contribution margin expresses the amount of revenue left to cover the potential profits and fixed costs. 

It is presented in a quantitative form which helps us to understand how it can help the company to achieve its targeted profit. It is often considered one of the most important components to guide the organization to meet its goal. That's why it is a very important and useful topic to be considered.

This ratio is very important as it evaluates the company's break-even point. That means it will determine at what point the company's revenue will be equal to its production cost. 

If a company has high variable costs due to its net sales, it might not have to cover many fixed monthly costs. 

This means the company will need to make a high profit to cover its fixed costs. So, that means it helps the company to survive in the market for a longer time without facing many obstacles. 

Sample Calculation

As discussed previously, calculating VCR is not very complex. It is an easy formula compared to other financial formulas. A real-life example can be used to calculate and understand how it is done and what significance it has in real life. 

Now let's have an example; suppose company X sells tennis rackets. 10,000 tennis rackets are sold per annum at $200 per unit. The VC per tennis racket is $150.

Total revenue from squash rackets is $600,000 per year. $400,000 is spent on materials and labor. Let's work out the company's contribution margin ratio using a VCR.

Solution

VCR tennis $150/$200= 75% 

VCR squash $400,000/ $600,000= 67%

Since the contribution margin ratio equals 1 – variable cost ratio, the contribution margin of a tennis racket is 25%, and that of a squash racket is 33% 

Composite VCR (($10,000* $150) + $400,000) /( $10,000* $200) + $600,000)) = 73%

Composite Contribution Margin Ratio 1-73%= 27%

Thus, we can calculate the ratio very easily if we know the value of the variable costs, fixed costs, units sold, sales, etc. 

We must be careful while calculating these values, or the outcome will be an error. Companies have been using these formulas to calculate variable costs for a long time. That's why we can conclude by saying that it's a significant factor. 

Article researched and authored by Mehnaz Tarannum | LinkedIn

Free Resources

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• Accrual Principle
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