Variable expenses are costs that fluctuate directly based on changes in production or sales. These costs increase as a company produces and sells more goods or services and decrease when production or sales decrease. Variable expenses commonly include materials, labor, and direct overhead costs to produce goods or services.
By expressing the variable expense ratio as a percentage of sales revenue, companies can evaluate the impact of variable costs on their profitability. Analyzing the variable expense ratio is useful for budgeting, cost control, and decision making. It can help companies understand how efficient they are at managing their variable costs, making pricing decisions, and evaluating the impact of changes in sales volume on their bottom line.
What is the variable expense ratio?
The variable expense ratio refers to the percentage of variable expenses over the company’s sales. The formula for the variable expense ratio is:
Variable expense ratio = (Total variable expenses / Total sales) x 100
For example, if a company has total sales of $1,000 and total variable expenses of $200, its variable expense ratio would be 20%.
Generally, a lower variable expense ratio is better than a higher one because it indicates that the company can be more profitable with scaling. One way is to compare it with previous periods to see if the company is becoming more or less efficient. Another way is to compare it with other companies in the same industry to see how well the company performs relative to its peers.
When interpreting the variable expense ratio, it is essential to remember that many factors can affect it. For example, a change in accounting methods may affect the numerator (total variable expenses) without affecting the denominator (total sales).
Fixed cost versus variable cost
Variable costs alone will not provide a holistic picture of your net profitability. You also have to consider fixed expenses. Fixed costs are associated with the essential operation and maintenance of a business and do not fluctuate with changes in production or sales revenue, such as equipment or rent.
Fixed and variable costs impact a company’s net profitability in different ways. Fixed costs establish a financial base that a company must cover before making a profit. These expenses remain constant, regardless of production or sales levels. Revenue earned beyond this fixed cost threshold contributes directly to net profitability. On the other hand, variable costs are linked to the cost of producing goods or services and increase along with the volume of production or sales. They directly influence cost of goods sold (COGS) and profit margin. Effective management of variable costs can help maintain or improve profit margins, which, in turn, improves net profitability. Striking the right balance between these cost categories and optimizing overall cost structures is critical for companies seeking to maximize their net profitability.
Ratio of variable expenses versus contribution margin
Contribution margin measures the amount of revenue left after covering variable expenses, indicating the profitability of a product or service. It can be calculated in absolute terms or as a percentage of sales and provides information on how much revenue is available to cover fixed costs and generate profits. The relationship with the Variable Expense ratio is:
Variable Expense Ratio = (Total Sales – Contribution Margin) / Total Sales
either
Contribution margin = Total sales * (1 – Variable expense ratio)
The Contribution Margin provides us with information about fixed costs, while the Variable Expense Ratio includes information about variable costs. Both metrics are crucial for cost analysis and decision making, with a lower variable expense ratio and higher contribution margin indicating a more favorable financial position.
Advantages of using the variable expense ratio
Various people and entities in the business world use the variable expense ratio. Business owners and managers use it to evaluate cost structures and make pricing decisions, while financial analysts rely on it to evaluate the financial health of a company.
The Variable Expense Ratio allows you to analyze the profitability and cost efficiency of the business. This allows the company to price products and provide profitability targets and projections.
1. Profitability evaluation: The variable expense ratio helps evaluate the profitability of products or services by revealing the portion of each sales dollar that goes to variable expenses. This information is crucial to identify which offers are most profitable and require optimization.
2. Pricing strategies: Helps establish pricing strategies by determining the minimum selling price needed to cover variable expenses. This information is invaluable for maintaining healthy profit margins and making informed pricing decisions.
3. Cost and Efficiency Control: The variable expense ratio is valuable for monitoring and controlling costs. By understanding the breakdown of various expenses, companies can identify areas to reduce costs and improve efficiency, leading to greater profitability.
These advantages make the variable expense ratio a critical metric for financial decision making and overall business performance.
Examples of variable expense ratios
Let’s consider a hypothetical example in the restaurant industry to demonstrate how to calculate and analyze the variable expense ratio.
You are the owner of a family restaurant, “Cafe Delight”. You want to understand your company’s cost structure and evaluate the profitability of your menu items. You decide to calculate and analyze your restaurant’s variable expense ratio.
Step 1: data
– Total monthly sales: $30,000
– Cost of Food Ingredients (variable cost): $9,000
– Labor Costs for Kitchen Staff (variable cost): $5,000
– Monthly Rent (fixed cost): $4,000
– Utilities and overhead (mixed costs): $2,000 (some variable, some fixed)
Step 2: Calculate the variable expense ratio
1. Calculate Total Variable Expenses:
Total variable expenses = Cost of food ingredients + Labor costs = $9,000 + $5,000 = $14,000
2. Calculate the variable expense ratio:
Variable expense ratio = (Total variable expenses / Total monthly sales) * 100
Variable expense ratio = ($14,000 / $30,000) * 100 ≈ 46.67%
Step 3: Analysis
With a variable expense ratio of about 46.67%, this means that for every dollar in sales, Cafe Delight spends about 46.67 cents on variable expenses, primarily food, ingredients, and labor.
Analysis of rentability: By understanding your variable expense ratio, you can evaluate the profitability of your menu items. For example, a dish that generates $10,000 in sales but has high variable costs may not be as profitable as a lower-cost dish that produces $5,000 in sales.
Prices for placing strategy: You can use the variable expense ratio to make pricing decisions. For example, if you introduce a new menu item with higher variable costs, you should set a higher selling price to maintain a desirable contribution margin.
Costs control: Monitoring your variable expense ratio over time helps you identify trends and fluctuations. If your variable expense ratio begins to increase, it could indicate inefficiencies in your kitchen operations or an increase in ingredient costs, prompting you to control costs.
Analysis breakeven point: You can use the variable expense ratio to estimate your breakeven point. Knowing that 46.67% of your sales go to variable expenses helps you determine the level of sales necessary to cover all costs (fixed and variable).
This analysis helps you make informed decisions to optimize your restaurant’s profitability. You can choose to adjust your menu, control ingredient costs, or establish appropriate pricing strategies to improve your financial performance while ensuring that your fixed expenses, such as rent and overhead, are covered by your income. .
