Variable Cost Ratio: Definition, Calculation & Importance

The variable cost ratio is a cost accounting tool used to express a company’s variable production costs as a percentage of its net sales. The ratio is calculated by dividing the variable costs by the net revenues of the company. The company’s net revenue includes the sum of its returns, allowances, and discounts subtracted from the total sales.

The primary motive for calculating the variable cost ratio is to consider costs that may be subject to variations with changes in levels of production and compare them to the amount of revenues generated by the sales of that particular cycle of production.

In calculating the ratio, fixed costs, which are the expenses that remain constant regardless of variations in production levels, are excluded. Examples of fixed costs include building lease, employee salariesRemunerationRemuneration is any type of compensation or payment that an individual or employee receives as payment for their services or the work that they do for an organization or company. It includes whatever base salary an employee receives, along with other types of payment that accrue during the course of their work, which, etc.

Summary

• The variable cost ratio is a cost accounting tool used to express a company’s variable production costs as a percentage of its net sales.
• The primary motive of calculating the ratio is to consider costs that may be subject to variations with the changes in production levels and compare them to the amount of revenues generated by the sales of that particular cycle of production.
• It is an important factor in determining the overall profitability of a company.

How to Calculate the Variable Cost Ratio

The formula for the calculation of the variable cost ratio is as follows:

Variable Cost Ratio = Variable Costs / Net Sales

An alternate formula is given below:

Variable Cost Ratio = 1 – Contribution Margin

The contribution margin is a quantitative expression of the difference between the company’s total sales revenue and the total variable costs of production of goods that were sold. The contribution margin is expressed in percentage points.

Sample Calculation

There are several ways in which the variable cost ratio can be calculated. Under the first method, the mathematical calculation is performed on a per-unit basis. In such a situation, consider a product with a per-unit variable cost of $10 and a per-unit sales price of $100. It gives a variable cost ratio of 0.1 or 10%.

The calculation can also be done by utilizing totals over a given period of time. Consider a situation wherein the total variable costs of production are $1,000 per month, and the total revenues generated per month are $10,000. The variable cost ratio, in this situation, is 0.1 or 10%.

Significance

The variable cost ratio is an important factor in determining the overall profitability of a company. It indicates whether the business can achieve a desirable balance of revenue streamsRevenue StreamsRevenue Streams are the various sources from which a business earns money from the sale of goods or provision of services. The types of such that a rise in revenues is faster than that of expenses. It is used to express in quantitative terms the relationship shared by the sales of a company and the particular costs of production that are associated with the revenues being considered.

The ratio is a useful evaluation metric for a company’s management to determine necessary break-evenBreak-even Point (BEP)Break-even point (BEP) is a term in accounting that refers to the situation where a company's revenues and expenses were equal within a specific accounting period. It means that there were no net profits or no net losses for the company - it "broke even". BEP may also refer to the revenues that are needed to be reached in order to compensate for the expenses incurred or minimum profit margins, make profit projections, and identify the optimal sales price for its products. In a situation where a company incurs high variable costs as a percentage of its net sales made, it is most likely that it does not need to cover a lot of fixed costs per month.

It means that the company will need to generate enough revenue to cover the fixed costs involved in the production process. It just enables the company to stay in business without generating any substantial profits from sales.

Additional Resources

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