Who Wants To Know More About Variable Cost, One Of The Key Components To Determining Break Even?
Knowing variable cost for your business is critical to determining key profitability information. Without it you cannot calculate break even. And you will be denied access to extremely important and usually actionable information.
You want to do a break even analysis to determine things like break even price, break even revenue volume, and break even unit volume. But without knowing your variable cost, you will get nowhere.
So let's take a hard look at it. It describes any cost that is directly related to an extra unit of sale. If you examine every one of your cost elements with that in mind, you won't go too far wrong. So let's look at a couple of examples that may help your understanding. The rent on your place of business. Does it increase if you sell one more unit of product? Of course not. Perhaps if you have a very peculiar type of rental agreement. What about shipping cost if any? It does increase by the cost of one additional shipment.
The example of shipping cost is a good one. The cost of one extra product in a shipment containing many similar products is unlikely to be as high as that same single product sent to another customer. So despite a fairly clear definition some costs don't fall into only one category. So some judgment is needed. But despite that apparent grey area, you can always get a useful working number. So don't get too caught up with the worrying about being precise.
If you multiply unit variable cost by unit volume, you will get total incremental cost. And this is an important working number. It is also important as there is frequently industry information available on various cost elements. If you find that yours are high relative to the industry standard, you may have an opportunity to take remedial action. Provided they are measuring the same things.
Businesses with a low unit cost structure can be highly advantageous. It means that once your business has reached break even, a large part of every extra dollar of revenue is profit. Provided the fixed cost is not too high, this describes a business with good underlying business economics.
On the other hand, businesses with high unit variable cost as a proportion of total cost, enjoy an advantage when conditions are difficult. Then a business where all costs were variable would carry the smallest risk. You might not make much of a profit, but you would never suffer a loss. This may be of little interest to a prospective buyer.
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