Variable Expense Ratio: What Is It And How To Calculate It
The variable expense ratio, sometimes called the variable cost ratio, is an accounting tool used to show an organization’s variable production costs as a percentage of net sales. It is part of cost-volume-profit analysis, otherwise known as a CVP analysis, which is an important part of many financial decisions.
In CVP analysis, the contribution income statement separates expenses into variable and fixed. The contribution margin – fixed expenses equal net income.
Producing goods increases both variable and fixed costs. Generally speaking, increasing production is more efficient for fixed costs like a building lease, because that price is fixed whether you make 1 unit or 100,000 units. The fixed cost per unit declines with the production increase.
Variable costs, on the other hand, like purchasing raw materials, labor, and utilities increase as production increases. You cannot make 1 unit for the same price as 100 units, because you need additional materials, the lights and equipment must operate longer, and staff must be available to handle production.
The variable cost ratio is an indicator of when the variable costs associated with increasing production exceed the benefits.
Calculating the Ratio
It is calculated by dividing variable costs by the net revenues of an organization, as shown:
Variable Cost Ratio = Variable Costs / Net Sales
The net revenue includes the sum of its returns, allowances, and discounts, subtracted from total sales.
Alternatively, this formula can be used:
Variable Cost Ratio = 1 – Contribution Margin
The contribution margin is the quantitative expression of the difference between the total sales revenue and the total variable costs of production of the goods that were sold. It is expressed in percentage points.
With the first method, the math is done on a per-unit basis. In this scenario, if a product has a per unit variable cost of $10, with a per-unit sales price of $100, there is a variable expense ratio of .1, or 10%.
You can also do this calculation with totals over a certain period of time. If the total variable costs of production are $1,000 per month, and the total generated revenue per month is 20,000, then the variable expense ratio in this situation is .05 or 5%.
The contribution margin is equal to 1 – the variable cost ratio. That means in the examples above, the contribution margin ratio would be either 90% or 95%.
You do not have to find the contribution margin of all the products individually, then obtaining the weighted average. it’s possible to use the variable cost ratio with the above formula to determine an average.
Most useful at the product level to determine profit margin, the variable cost ratio is also helpful at the organizational level because it helps determine the number of fixed costs incurred.
What is the Contribution Margin?
The contribution margin is a product’s price, minus all the associated variable costs. It is the incremental profit earned for each unit sold, for a single product. It is the amount of sales available to cover fixed expenses, and if there is a remaining balance, it provides the profit for the period. If the margin isn’t large enough to cover the fixed expenses, there is a net loss for the period.
The total contribution margin a business generates represents the total revenue available to pay for fixed expenses and earn a profit. The contribution margin complements the variable expense ratio.
The contribution margin is a good way to determine if a company can afford to put a product on sale for a certain price and still hit its target profit goals.
Contribution margin is calculated with this formula:
(Net product revenue – Product variable costs) ÷ Product revenue
For example, a company sells $1,000,000 worth of guitars in the most recent period. The related variable costs were $400,000. The related fixed costs were $660,000 for the same period. The company lost $60,000.
The contribution margin is 60%, meaning that if the company wants to break even, it must either reduce fixed costs by $60,000 or increase sales by $100,000 ($60,000 loss divided by the 60% contribution margin).
At the breakeven point, operating income is zero. The total revenue is equal to total expenses, and fixed expenses equal the contribution margin.
It’s important to consider that the contribution margin doesn’t consider the impact of a product on a bottleneck operation within an organization. It may be acceptable to have a low contribution margin if there is little to no processing time by the bottleneck.
Fixed Expenses vs. Variable Costs
Fixed expenses are those that don’t change with sales volume or production. These are things like building rent or mortgage, insurance, equipment leases, loan payments, and managerial salaries. Your fixed expenses are your contribution margin.
Variable costs are those that change based on volume or activity level, such as hourly wages, raw materials, inventory, shipping costs, packaging supplies, and so on.
Why the Variable Expense Ratio Matters
The variable cost ratio helps determine how profitable a company is. It serves as an indicator of whether a company can achieve a balance of revenue streams where the revenue grows faster than the expenses. The ratio helps to determine the necessary break-even point so it is easier to determine the optimal selling price and make profit projections.
In companies producing a single product, the CM ratio relationship applies to the either the total sales dollars and the total contribution margin, or the per-unit sales dollars and contribution margin dollars.
In companies that produce multiple products, each product has its own cm ratio. The CM for the entire company is calculated only for total contribution margin dollars as a percent of total sales dollars.
When organizations have high variable costs as a percent of their net sales, it means that most likely, there are not a lot of fixed costs to cover every month. It means a business has to generate enough revenue so that it can cover the fixed costs in the production process, allowing the business to stay operational without making any significant profit from sales. With high ratios, a company can make profits on relatively low sales because there are only modest fixed costs.
When organizations have a low variable expense ratio, it implies the breakeven point is high, because the income is necessary to pay for a large volume of fixed costs. Because of this, a high sales volume has to occur before any profit is made.