How much does it cost your business to produce the things you sell, and how does that cost compare to your sales revenue?
These are essential questions for any business. The answers can provide key insights into your profitability, how you can best allocate your resources, and where you should focus your efforts when it comes to business growth.
As obvious as these questions are to ask, answering them can be complicated. Many businesses track their variable expense ratio to get at the heart of these questions, making it a vital north-star metric for many finance teams.
What are variable expenses?
One of the key ways that accountants and accounting teams think about business expenses is to split them up into variable expenses and fixed expenses.
To understand what the variable expense ratio is and what it really measures, the first step is to understand the difference between those two kinds of expenses.
Definition of variable expenses
Variable expenses are all of the expenses that change based on the number of units your company produces. They’re called “variable” because they vary with production.
If your company produces ceramic flower pots, for example, every pot you make requires a certain amount of clay. That's a variable expense. The amount of clay you need to buy depends on the number of flower pots you want to make.
Definition of fixed expenses
Fixed expenses, on the other hand, don’t change no matter how much you produce. If you rent a building for your flower pot company, your monthly rent is a fixed expense. You owe the same amount of money every month whether your company produces thousands of pots or none at all.
Examples of variable expenses
Let’s start with an example of a simple production facility. Imagine that you lease a small pottery studio where you and two employees create handmade flower pots to sell in an exclusive local boutique.
Your variable expenses include:
- Clay for making the pots
- Water to keep the clay workable
- Soap and more water for cleaning up
- Packaging to keep the pots from breaking
- Shipping and/or transportation costs
- Any kWh of electricity that you use in making pots
Your fixed expenses include:
- Employees’ fixed salary
- Lease payments
- Website fees under an annual contract
- Any minimum utility fees or electricity you use regardless of your flower pot production, such as keeping the lights on at night for security or powering a refrigerator
The key distinction is that variable expenses increase if you produce one more unit. Your fixed expenses, on the other hand, don’t change based on your level of production.
What is a variable expense ratio?
A variable expense ratio is a measure of how much a company has to pay in variable expenses to produce a certain number of units, as compared to the amount of money the company receives for selling those units.
It’s also known as a variable cost ratio.
How to calculate variable expense ratio
Variable expense ratio looks at variable expenses as a parcentage of company sales. To compute your variable expense ratio, start with the total amount you paid in variable expenses during a given time period, and divide that by the sales revenue you produced during that same time period.
For example, if you paid $25,000 in variable expenses in the first quarter of the year, and you made $100,000 in sales during that same quarter, your variable expense ratio would be 25%.
In other words, your variable expenses were 25% of your sales revenue.
Variable expense ratio formula
The formula for calculating your variable expense ratio is quite simple:
Variable expense ratio = variable expenses / sales revenue
To express the result as a percentage, multiply it by 100.
Related metrics: contribution margin ratio
Another cost accounting metric that’s related to your variable expense ratio is your contribution margin ratio, or CM ratio. The easiest way to calculate it is to subtract your variable expense ratio, expressed as a percentage, from 100.
Contribution margin ratio = 100 - variable expense ratio %
If your variable cost ratio is 15%, your CM ratio is the other 85%. If your variable cost ratio is 30%, your CM ratio is the other 70%.
It’s called the contribution margin ratio because it represents the portion of each sale that can contribute to your bottom line, first covering your fixed costs (your break-even sales) and then growing your profits.
For example, if your variable cost ratio is 25%, then your CM ratio is 75%. So, $0.25 out of every $1.00 in your net sales (after losses and returns) goes toward the variable cost of production. The remaining $0.75 contributes to your fixed costs until you reach your break-even point and then contributes to your profits.
Important factors to remember in calculating your variable expense ratio
- Use a consistent time period. Make sure you measure your variable expenses and your net revenue over the same time period before you plug them into the formula. The math only works if both measurements cover the same time frame.
- Choose total basis or unit basis. You can use the formula above with total variable costs and total sales dollars or unit variable costs and unit sales. To use total costs and total sales revenue, enter your totals for each into the formula, just be sure to measure them over the same time period. To use unit costs and revenue, calculate your per-unit variable costs and per-unit selling price first, then enter those into the formula instead.
- Define sales revenue carefully. For the formula above, your sales volume only includes the amount of revenue you get to keep after you subtract out any returns and losses. Also, make sure you’re comparing apples to apples. If you want to know the variable expense ratio for a single product line, you’ll need to use your variable expenses and sales revenues for just that product line.
- Measuring variable expenses can be tricky. The utility line items in the example above are just the tip of the iceberg when it comes to measuring variable expenses. Does your utility bill have a minimum fee for reading the meter every month? That’s a fixed expense. Do you heat and cool the building to protect your equipment 24/7? That’s a fixed expense too. But how much electricity does that take? What part of your total bill is fixed and what part is variable?
In the real world, many financial ratios and other accounting metrics aren’t perfect. Every managerial accounting team needs to decide for itself how much time and effort it’s worth to try to calculate its variable expenses down to the penny.
For example, the fixed portion of your utility bill might be so small that it makes more sense to call the entire bill variable. On the other hand, the fixed portion could be so large that it isn’t worth trying to tease out that variable cost.
The key is to understand what you’re really trying to measure and why, so you can decide for yourself how precise you need to be in making sound financial decisions for your company.
Why is your variable expense ratio important?
Accountants and finance teams measure and track variable expense ratios for several reasons. Here are just a few of the ways that some companies use it, in combination with their income statement and other financial statements, in making important business decisions:
- Changing sales prices to meet the rising costs of production
- Determining how many units they need to sell to cover fixed costs (break-even analysis)
- Identifying and capturing economies of scale
- Planning future production by optimizing costs vs revenues
- Setting aside the cash needed to cover raw materials and other production costs
Once you know and understand your variable expense ratio, tracking it over time can help you identify changes in your cost structure sooner rather than later.
If economic conditions change suddenly, this kind of cost-volume-profit analysis (CVP analysis) can prepare your company’s management team to react to those changes quickly, meeting new challenges head-on.
What is a good variable expense ratio?
The best variable expense ratio for your specific organization depends on your business model.
For example, a law firm with high salaries and expensive downtown offices might need to keep its variable expense ratio very low to cover that fixed overhead and meet its total expenses. It can’t afford to put a lot of money into investigations and expert witnesses unless its cases have a high potential payout.
On the other hand, a graphic design agency that uses remote, independent contractors for its production work will have a relatively high variable cost ratio, but it will also have low fixed costs. It can afford that high variable expense ratio because it can reach its break-even point quickly, covering its fixed expenses with a relatively low number of projects.
A good variable expense ratio is one that leaves you enough sales revenue to cover your fixed expenses with a comfortable target profit margin. Once you set that target, the important thing is to track your ratio closely enough to notice any rising trends early — giving you enough time to adjust your prices, your business model, or both to meet your company’s changing needs.
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