Are Variable Costs Really Variable?
What is a Variable Cost?
A variable cost is an expense that is directly related to the sale of a product or service and therefore increases and decreases as sales increase and decrease. Examples of variable costs are the cost of goods sold and the cost of labor to produce the product that is sold.
Variable Costs in Food
In the food service industry sometimes this is called the “prime.” So if the cost of goods is 23% and the cost of labor is 27% then the prime is 50% which consequently means that your gross margin is also 50%. Basically for every $1 in sales you will have $.50 remaining after the expenses to fulfill the sale in order to cover fixed costs and then derive a profit.
When managers are thinking about the impact of changes in sales they consider variable costs as percentages that remain fixed. So at $1,000 a week in sales my COGS is 23% (or $230) and at $10,000 a week in sales my COGS is 23% (or $2,300). This is a simplified model and works for “back of the envelope” calculations and projections, however assuming that variable costs are always in direct proportion to sales is misleading and often inaccurate.
Variable Costs Have a Fixed Component
In reality, variable costs are not completely variable, there is a fixed component to them which is not determined by sales but is determined when your company commits to a certain cost structure and capacity.
For example, most companies set the schedule for their production team before they know exactly how much volume needs to be produced. They will commit to a certain number of labor hours (full time and part time employees) to have scheduled before knowing sales day to day and week to week. This means that while in theory labor changes as sales changes, in reality there is a fixed component to it at least in the short term. It’s possible of course to change the number of budgeted labor hours reactively to changes in sales, for example by letting employees go if sales volume slips over time, but these decisions are not immediate and in fact may have longer term consequences in terms of turnover and employee morale.
COGS Are Capacity Dependent Variable Costs
COGS poses a similar issue; it seems straightforward that if my product costs $2 to make it will always cost $2 to make and therefore if I sell it for $10 my COGS is 20% regardless of how many units I produce. But, in reality, it is much easier to keep COGS low and to possible reduce it further when sales are higher. In this example, at 100 units of sales my COGS might be 20%, but at 1,000 units is might be closer to 18%.
Several factors are at play here: in a food service setting, many supplies and other items that get bundled into COGS do not actually increase in direct proportion to increases in volume. I use one trash bag at my station regardless if I make 10 units or 100 units and the cost of that trash bag gets spread across those units equally so that at 100 units it is cheaper than at 10. Additionally, there is less waste at higher volumes: let’s say that my product calls for canned tomato sauce. If I am making one serving I have to open that sauce and potentially it will spoil out before it is completely used. But if I am making 20 servings, the exact amount that is in that can, none goes bad and so my spoilage is 0. The other, larger factor, is that with higher volumes of purchasing it is easier to negotiate lower pricing on raw goods.
Understand Your Variable Costs
So, we have looked at why variable costs are not truly variable and why they will in fact change with changes in sales and not always be a flat percentage. Why is this important? Well, it’s good to understand that you might see some cost advantages to growth, but it is also important to see that you may have to make changes to your cost structure to support that growth.
Will you need to increase the number of production employees you have and, if so, will you be able to have the sales going forward to keep them busy all the time? Remember, they don’t just come in for your busy week and then stop working when you get slow again. If you are expecting a slow period coming up, should you assume that COGS might increase as well?
It is important to fully understand your variable costs and therefore gross margin when planning for the future so that you know exactly how much you can expect to be leftover to cover fixed costs and to provide a profit for the business.