## 3. Variable costs

Variable costs change in direct proportion to changes in the level of activity (i.e., cost driver).

Direct materials and direct labor costs are generally classified as variable costs. Variable costs are the same per unit, while the total variable costs change in proportion to the changes in the cost driver (i.e., activity base).

Let us return to our example of valve production and Friends Company. Each valve will require a component part (i.e., raw material, variable cost). Component parts are purchased from outside suppliers for \$10 per part. Friends Company's production capacity is 10,000 to 50,000 valves per year.

Illustration 1 shows material (component part) costs for valve production in the range of 10,000 - 50,000 units per year:

Illustration 1: Variable cost of valves at different production levels

 Valves Produced Cost of One Valve Total Cost of Vales Calculation 10,000 \$10 \$100,000 10,000 x \$10 20,000 \$10 \$200,000 20,000 x \$10 30,000 \$10 \$300,000 30,000 x \$10 40,000 \$10 \$400,000 40,000 x \$10 50,000 \$10 \$500,000 50,000 x \$10

From the table above you see that the total cost of valves changes in direct proportion to the number of units produced. The unit cost, however, stays the same and does not depend on the output volume.

The variable costs from the preceding table can be easily presented in a graph. Illustration 2 demonstrates how the variable costs for valves behave as total production changes. The graph shows the same data, but in a different way. Note that the variable cost line starts at zero cost for zero production and increases gradually with the increase in the number of valves produced:

Illustration 2: Total variable cost graph To contrast the total variable cost with the cost per unit when production increases, we created another graph (Illustration 3). In the graph the variable cost per unit remains the same regardless of production level, while in Illustration 2 the total variable cost increases as production increases. The reason is because regardless of how many component parts Friends Company has to buy, the price is the same: \$10 per unit (we don't consider bulk discounts). At the same time, if Friends Company produces more valves, the company will need to buy more component parts and the total cost will increase.

In the graph below note that the unit cost line starts at the \$10 point and remains constant with the increase in the number of units purchased:

Illustration 3: Unit variable cost graph Material cost is only one example of variable costs. Illustration 4 provides more examples of variable costs along with their cost drivers for various types of businesses:

Illustration 4: Examples of variable costs

 Type of Business Cost Cost Driver Manufacturing Direct Materials Number of units produced Restaurant Payroll Number of hours worked Taxi Fuel Number of miles driven Hotel Housekeeping costs Number of rooms occupied Printing company Paper Number of pages printed Hospital Food cost Number of patients served
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