What Is Variable Cost Ratio? A Simple Guide for Investors

The variable cost ratio is a key metric for determining the profitability of business operations. It helps you evaluate if the additional variable costs incurred based on the level of production are matched or justified by the additional sales or revenue generated. With the variable cost ratio calculation, you can compare the increased sales with the increased variable production costs and decide if the balance is optimal.

In this article, we delve into what the variable cost ratio is, check out the variable cost ratio formula and its significance, and discuss how to interpret the ratio.

The variable cost ratio (VC ratio) is an accounting metric that compares the variable costs of production with the net sales over a given period. The net sales (or net revenue) is the total sale value, adjusted for discounts, returns and allowances. By comparing these two values, the ratio helps businesses estimate if the extra costs incurred for increasing the production levels are compensated sufficiently by the added revenue generated from this added production.

By checking the variable cost ratio, companies can decide if their variable costs are too high, moderate or optimal. This, in turn, can help drive decisions about profitability, cost-cutting, product pricing and other core aspects.

Also read: What is a current ratio

• The variable cost ratio is an important accounting tool that compares the variable costs incurred with the additional net sales generated.

• A high variable cost ratio is a sign that the profit margin is low, while a low ratio means that the variable costs do not erode the additional sales generated.

• Together, the variable cost ratio and the contribution margin ratio make up 100% of the net sales.

The variable cost ratio formula is easily deciphered from its meaning itself. Now that you know what the variable cost ratio is, check out the formula used to calculate this ratio below:

Variable cost ratio = Variable costs ÷ Net sales

Keep in mind that the value of the net sales and not the total sales is used in the variable cost ratio calculation. Aside from this formula, you can also use a different method to calculate the VC ratio if you know the contribution margin ratio. This is the variable cost ratio formula using this metric:

Variable cost ratio = 1 — Contribution margin ratio

The contribution margin represents the margin or additional revenue from each product sold. It is the difference between the net sales and variable costs, divided by the net sale value.

Also read: What is the cash ratio

To calculate this ratio using the net sales and total variable costs for a given period, you can use the following steps.

• Step 1: Identify the total net sales for a specific period (like one month, six months or one year).

• Step 2: For the same period, find the total variable costs directly linked to the additional production.

• Step 3: Find the sum of the variable costs.

• Step 4: Divide the total variable costs by the net sales to find the ratio.

Another way to compute the ratio is to use the variable costs incurred and net sales generated per unit (instead of the total variable costs and net sales used in the example above).

Also read: What is a Treynor Ratio

The steps involved in calculating the ratio depend on the type of data available. Let us discuss an example to understand how the variable cost ratio calculation works.

Business context

A small manufacturing firm specialises in the production of electronic components for various industries. With a small team of employees and a semi-automated production line, the business focuses on quick turnaround times for custom orders. Its variable costs include direct material, labour charges and commissions, among others.

Pricing and costs

Consider the following data from the company over one month:

• Net sales: Rs. 1,00,000

• Direct material costs: Rs. 20,000

• Direct labour costs: Rs. 30,000

• Sales commissions: Rs. 5,000

• Shipping and packaging: Rs. 5,000

Variable cost ratio calculation

To calculate the variable cost ratio from the above data, you need to first sum up all the variable costs. This comes up to a total of Rs. 60,000. Then, you need to use the variable cost ratio formula to find the value. This gives us a ratio of 60% or 0.60 (i.e. Rs. 60,000 ÷ Rs. 1,00,000).

Also read: What is the quick ratio

This ratio is crucial in cost analysis and management decision-making. It offers valuable insights into a company’s costing structure and operational efficiency. With this metric, businesses can understand how their costs fluctuate with changes in production or sales volumes.

A lower ratio indicates that a smaller portion of the additional revenue is used to meet variable costs. This could potentially lead to higher profitability. The ratio is also vital for making pricing decisions as it helps identify the minimum price point that can meet the variable and fixed costs and still leave room for profits. This helps businesses set realistic yet competitive prices for their products or services.

Additionally, the variable cost ratio is also significant in break-even analysis. Here, it helps calculate the contribution margin, which, in turn, determines the break-even price point. This helps businesses understand how many units they need to sell to cover all costs and break even.

The ratio also helps with performance evaluation and cost control. By tracking this ratio over time, a business can assess how effective its cost-reduction techniques are and identify areas for improvement.

Also read: What is an expense ratio

Now that you know what the variable cost ratio is and how it is calculated, let us see how you can interpret it. Say a company’s VC ratio is 60%, as we saw in the earlier example. This means that variable expenses take up 60% of the company’s net sales. Only the remaining 40% is available for the company to account for its fixed costs and profits.

This may not always be an ideal situation. The lower the variable cost ratio is, the better it is for the overall profitability of a company. A lower VC ratio also gives businesses more flexibility in pricing because they can afford to offer discounts without negatively impacting profits. This, in turn, can turn into a competitive advantage for the enterprise.

Understanding this ratio is crucial for businesses that want to optimise their profitability and operational efficiency. That said, while this ratio is important for financial analysis, it is necessary to also consider other metrics for a comprehensive overview of a company’s performance.

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