variable cost

Examples of variable cost in the following topics:

• Defining Operating Leverage

  • Operating leverage can be defined, simply, as the degree to which a firm incurs a combination of fixed and variable costs.
  • Specifically, it is the use of fixed costs over variable costs in production.
  • For example, replacing production workers (variable cost) with robots (fixed cost) .
  • These include the ratio of fixed costs to total costs, the ratio of fixed costs to variable costs, and the Degree of Operating Leverage (DOL).
  • The ratios of fixed cost to total costs and fixed costs to variable costs tell us that if the unit variable cost is constant, then as sales increase, operating leverage decreases.

• Leverage Models

  • The relationship between fixed and variable costs, when calculated alongside sales volume, enables modeling of operational leverage.
  • When fixed costs are high (and variable costs are low), there is quite a bit of risk if the volume of production is low.
  • What's important to keep in mind is the importance of fixed costs compared to variable costs, and the impact this can have on financial leverage.
  • As you can see, your variable cost is only 10% of the overall revenue.
  • So, the model for leverage in this case is fixed costs/total costs (or fixed costs/fixed costs + variable costs):

• Break-Even Analysis

  • The variable cost per unit is $5, and the total fixed costs are $1,000. 67 units must be sold in order to break even.
  • Recall that operating leverage describes the relationship between fixed and variable costs.
  • Having high operating leverage (having a larger proportion of fixed costs compared to variable costs) can lead to much higher profits for a company.
  • It is simply the unit net revenue minus the unit variable cost.
  • Contribution margin (C) is the unit net revenue (P = price) minus unit variable cost (V = variable cost).

• Benefits and Risks of Operating Leverage

  • When considering the benefits of operating leverage, it is appropriate to consider the contribution margin, or the excess of sales over variable costs.
  • When variable costs are lower, the contribution of sales to profits will be greater.
  • For example, the variable costs for a software company, such as packaging and the cost of various media devices (like CDs), are very low compared to its fixed costs, such as research and development.
  • Therefore, once a certain break-even point is reached, the contribution that sales make to profits is much higher than it would be if a greater portion of the costs were variable.
  • Problems can arise if a company has very high fixed costs, and if a company has difficulty selling enough units to break even on a particular investment.

• Economic Order Quantity Technique

  • Variables for the function are: Q = order quantity, Q*= optimal order quantity, D = annual demand quantity, S = fixed cost per order (not per unit, typically cost of ordering and shipping and handling.
  • This is not the cost of goods), H = annual holding cost per unit (also known as carrying cost or storage cost) (warehouse space, refrigeration, insurance, etc., usually not related to the unit cost).
  • Total Cost = purchase cost + ordering cost + holding cost
  • Purchase cost: This is the variable cost of goods: purchase unit price × annual demand quantity.
  • To determine the minimum point of the total cost curve, partially differentiate the total cost with respect to Q (assume all other variables are constant) and set to 0:

• Comparing Interest Rates

  • Variables, such as compounding, inflation, and the cost of capital must be considered before comparing interest rates.
  • Another major consideration is whether or not the interest rate is higher than your cost of capital.
  • Many companies have a standard cost of capital that they use to determine whether or not an investment is worthwhile.
  • Even if a 10% annual return sounds really nice, a company with a 13% cost of capital will not make that investment.
  • Discuss the differences between effective interest rates, real interest rates, and cost of capital

• Inputs to COGS

  • Cost of goods sold (COGS) refer to the inventory costs of the goods a business has sold during a particular period.
  • Costs include all costs of purchase, costs of conversion, and other costs incurred in bringing the inventories to their present location and condition.
  • Costs of payroll taxes and employee benefits are generally included in labor costs, but may be treated as overhead costs.
  • Activity based costing attempts to allocate costs based on those factors that drive the business to incur the costs.
  • Variable production overheads are allocated to units produced based on actual use of production facilities.

• Problems with WACC

  • Problems arise in calculating components of WACC because differing methods and proxy values result in widely varying costs of capital.
  • The primary variables to be determined in order to calculate weighted average cost of capital are the relative debt and equity values, the cost of debt, and the cost of equity.
  • While calculating cost of debt is more simplistic, relative to calculating cost of equity, there are still problems that arise.
  • To calculate cost of debt, we add a default premium to the risk-free rate.
  • Identify the problems with using the Weighted Average Cost of Capital

• Calculating the NPV

  • The other integral input variable for calculating NPV is the discount rate.
  • A firm's weighted average cost of capital after tax (WACC) is often used.
  • The business will receive regular payments, represented by variable R, for a period of time.
  • This period of time is expressed in variable t.
  • The payments are discounted using a selected interest rate, signified by the i variable.

• The Cost of Preferred Stock

  • The cost of preferred stock is equal to the preferred dividend divided by the preferred stock price, plus the expected growth rate.
  • The cost of preferred stock is 13%.
  • Because preferred stock carries a differing amount of risk than other types of securities, we must calculate its asset specific cost of capital to work into our overall weighted average cost of capital.
  • This is different than common stock, which has variable dividends that are never guaranteed.
  • The cost of preferred stock is equal to the preferred dividend divided by the preferred stock price, plus the growth rate.