Variable expense ratio — also called the variable cost ratio — is a means of understanding how variable costs impact a business’s net profits.
The variable expense ratio expresses a company’s variable expenses as a percentage of its net sales. This is a useful metric that can help businesses in matters like pricing and production scheduling.
Intrigued? This article will explore how the variable expense ratio is calculated and where it’s used. Keep reading to learn more about why this is such an important business metric.
What is a Variable Expense?
Business expenses can be classified as either fixed (invariable) or variable.
A fixed expense does not change based on a business’s other activities. Costs like rent and administrative salaries are fixed costs, which remain the same no matter how much a business is producing. Imagine a factory that produces pencils — the cost of renting the factory building will remain the same, month after month, no matter how many pencils the company actually produces.
A variable expense, on the other hand, is pegged to a company’s productivity or sales. The expense rises as the company produces more and falls as the company produces less.
The cost of materials is a variable expense. To return to the example of the pencil factory — the cost of wood and graphite will go up as the factory increases production because making more pencils requires more wood and graphite. The cost will go down if the factory reduces production.
Other variable expenses might include commissions for sales representatives or anyone else on staff who is paid based on productivity. A company will pay more to its sales staff as sales rise and less as sales fall.
How To Calculate the Variable Expense Ratio
Variable expense ratio expresses variable expenses as a proportion of a company’s sales.
To calculate the variable expense ratio, simply divide the company’s total variable expenses by the company’s total net sales. To express the result as a percentage, simply multiply it by 100.
For example, if our pencil company earns $1,000 and the variable expenses for that period total $600, then the variable expenses are 60% of the sales.
Calculating Variable Expenses and the Contribution Margin
Some people prefer to calculate variable expenses by looking at the contribution margin.
A contribution margin is the amount of revenue that a business has left over after deducting its variable costs. In other words, it’s the sum that a company can use to pay for its fixed expenses (like rent and salaries) once the variable expenses associated with production have been paid.
Some analysts like to calculate the variable expense ratio by subtracting the contribution margin from the number one. Formulaically, that’s 1 – contribution margin.
No matter which calculation is used, the variable expense ratio is a valuable metric.
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Importance of the Variable Expense Ratio
The Variable Expense Ratio allows businesses to carry out a cost-volume profit, or CVP analysis, with great accuracy. This, in turn, allows them to set reasonable prices for products as well as production goals.
Let’s return to the example of the pencil company that earned $1,000 and spent $600 on variable expenses. As we have seen, that company’s variable expenses make up 60% of its net income.
That percentage will remain steady no matter what the production level is. If the company doubles its production and earns $2,000 in pencil sales, its variable costs will increase to $1,200. If, on the other hand, the company slashes its production by half, its variable costs will drop to $300.
This is an invaluable planning tool since it allows management to predict exactly what its total expenditures will be. Of course, determining the variable expense ratio also allows businesses to decide whether increasing production is a good strategy or not.
Knowing the variable cost ratio also allows management to determine the contribution margin and exactly how much profit the company can expect to see, based on its production level. Knowing this can also help businesses determine a reasonable price for a product, based on how much it costs to produce that product.
Variable Expense Ratio Examples
It’s possible to calculate the variable expense ratio for virtually any time period — it can be calculated for the full financial year, by quarter, or even by month or week. The variable expense ratio can also be worked out per unit.
Imagine, for example, that a sporting goods company is selling a hiking backpack for $100. (This is a top-of-the-line backpack, made from durable and waterproof material, with room for a sleeping roll and water bottles.) The backpack has a variable expense of $10.
To calculate the variable cost ratio of the backpack, we divide the variable cost ($10) by the sales revenue ($100). The result is 0.1. Multiplying that by 100, we get 10%.
It’s also possible to calculate the variable expense ratio over a period of time. Imagine that the same sporting goods company is selling a line of tennis rackets. Over a period of a month, sales reach $20,000. The variable cost of producing those water bottles is $1,000.
To determine the variable cost ratio for that month, we simply divide the variable cost ($1,000) by the sales revenue ($20,000). The result is 0.05, which is equivalent to 5%.
To determine the contribution margin, simply use the calculation 1 – variable cost ratio. You can then multiply the result by 100 to express the result as a percentage. So, in the case of the hiking backpack, the contribution margin would be 90%. The contribution margin for the month of tennis racket sales would be 95%.
Who Uses the Variable Expense Ratio?
The variable expense ratio is a useful metric for any business. It’s particularly important for companies that are working to increase their operational efficiency by cutting costs. That’s because the variable expense ratio can help businesses decide where increasing production makes sense and where it doesn’t.
As your business improves its operational efficiency, it will likely benefit from working with a global payables solution like Tipalti. Tipalti can help you to automate your workflows and remain compliant with all relevant legislation wherever you do business, so that you continue to scale smoothly and effectively.