How To Find Variable Cost Of Goods Sold

Understanding how to find the variable cost of goods sold (COGS) is crucial for any business aiming to accurately assess profitability and optimize operations. Variable COGS, unlike fixed costs, fluctuates directly with the level of production or sales, providing vital insights into the true cost of each product or service. This article delves into the intricacies of calculating variable COGS, offering a step-by-step guide and practical examples to help you master this essential accounting skill.

Understanding Variable Costs vs. Fixed Costs

Before diving into the specifics of finding variable COGS, it's important to differentiate between variable costs and fixed costs. Variable costs change in proportion to the volume of production or sales. Examples include raw materials, direct labor, and packaging costs. Fixed costs, on the other hand, remain constant regardless of production levels, such as rent, salaries, and insurance.

• Variable Costs: Costs that change with production volume.
• Fixed Costs: Costs that remain constant regardless of production volume.

The ability to distinguish between these two types of costs is fundamental to accurately calculating variable COGS and understanding your business's cost structure.

What is Variable Cost of Goods Sold (COGS)?

Variable Cost of Goods Sold (COGS) represents the portion of your Cost of Goods Sold that varies directly with the level of production. In simpler terms, it's the cost of the inputs that go directly into creating a product and delivering it to customers. Variable COGS can include costs like:

• Raw Materials: The cost of the direct materials used in production.
• Direct Labor: The wages and benefits paid to workers directly involved in the manufacturing process.
• Packaging Costs: The cost of materials used to package the finished goods for sale.
• Shipping Costs: The costs associated with shipping goods to customers (only if directly tied to the number of units sold).
• Commissions: Sales commissions paid to sales staff if they are directly tied to sales volume.
• Utilities: Portion of the factory utilities (electricity, gas, water) directly related to production volume.
• Supplies: Cost of supplies used in the production process.

Why is Variable COGS Important?

Understanding your variable COGS is crucial for several reasons:

• Accurate Profitability Analysis: By isolating variable COGS, you can more accurately determine the profitability of each product or service.
• Pricing Strategies: Knowing your variable costs helps you set competitive prices that cover your costs and generate a profit.
• Cost Control: Identifying the components of variable COGS allows you to focus on areas where you can reduce costs and improve efficiency.
• Break-Even Analysis: Variable COGS is a key input in break-even analysis, which helps you determine the sales volume needed to cover all costs.
• Marginal Analysis: Understanding variable COGS enables you to make informed decisions about accepting or rejecting new orders, based on whether the incremental revenue exceeds the incremental variable costs.

Step-by-Step Guide to Finding Variable COGS

Here's a comprehensive step-by-step guide to calculating variable COGS:

Step 1: Identify All Costs Associated with Production

The first step is to identify all costs that are directly related to the production or sale of your goods. This includes everything from raw materials to direct labor. Make a comprehensive list of all potential cost components.

Step 2: Classify Costs as Variable or Fixed

Next, you need to classify each cost as either variable or fixed. Remember, variable costs change with production volume, while fixed costs remain constant. This step requires a thorough understanding of your business operations and cost structure. It's helpful to review historical data and consult with your accounting team or financial advisor.

Step 3: Calculate Total Variable Costs

Once you've identified all the variable costs, sum them up to calculate the total variable costs. This is a straightforward calculation, but it's important to ensure you've included all relevant costs.

Step 4: Determine the Proportion of Variable Costs Included in COGS

Not all variable costs are necessarily included in COGS. For example, marketing and administrative expenses are typically considered period costs and are not included in COGS. You need to determine which variable costs are directly attributable to the production or sale of goods.

Step 5: Calculate Variable COGS

Once you've determined the proportion of variable costs that are included in COGS, you can calculate the variable COGS. The most common formula is:

Variable COGS = (Beginning Inventory + Purchases - Ending Inventory) x Variable Cost Percentage

Where:

• Beginning Inventory: The value of inventory at the beginning of the accounting period.
• Purchases: The cost of goods purchased during the accounting period.
• Ending Inventory: The value of inventory at the end of the accounting period.
• Variable Cost Percentage: The percentage of the total cost of goods sold that is variable.

Alternatively, you can calculate Variable COGS by summing up all the individual variable cost components directly related to production.

Step 6: Verify and Refine Your Calculation

After calculating the variable COGS, it's essential to verify the accuracy of your calculation. Compare your results with previous periods and investigate any significant variances. You may also want to consult with your accounting team or financial advisor to ensure your calculation is accurate and consistent with accounting principles.

Detailed Breakdown of Variable COGS Components

Let's take a closer look at each of the key components of variable COGS:

1. Raw Materials:

• Definition: The cost of the direct materials used in the production process.
• Examples: Wood for furniture, metal for appliances, fabric for clothing, ingredients for food products.
• Calculation: Track the quantity of raw materials used in production and multiply by the cost per unit.
• Tips: Implement a robust inventory management system to accurately track raw material usage. Negotiate favorable pricing with suppliers to reduce raw material costs.

2. Direct Labor:

• Definition: The wages and benefits paid to workers directly involved in the manufacturing process.
• Examples: Assembly line workers, machine operators, painters, welders.
• Calculation: Track the hours worked by direct labor employees and multiply by their hourly wage rate. Include any related benefits, such as payroll taxes and insurance.
• Tips: Implement time tracking software to accurately record direct labor hours. Invest in training and development to improve employee productivity.

3. Packaging Costs:

• Definition: The cost of materials used to package the finished goods for sale.
• Examples: Boxes, bags, labels, tape, shrink wrap.
• Calculation: Track the quantity of packaging materials used and multiply by the cost per unit.
• Tips: Explore different packaging options to find the most cost-effective solution. Consider using recycled or sustainable packaging materials to reduce costs and environmental impact.

4. Shipping Costs (Directly Tied to Sales Volume):

• Definition: The costs associated with shipping goods to customers, but only if directly tied to the number of units sold.
• Examples: Freight charges, delivery fees, insurance costs.
• Calculation: Track shipping costs per unit and multiply by the number of units sold.
• Tips: Negotiate shipping rates with carriers to reduce transportation costs. Optimize packaging and shipping processes to improve efficiency.

5. Commissions:

• Definition: Sales commissions paid to sales staff if they are directly tied to sales volume.
• Examples: Percentage of sales revenue paid to sales representatives.
• Calculation: Track commission rates and sales volume to calculate total commission expense.
• Tips: Design a commission structure that motivates sales staff to increase sales volume. Monitor commission expenses to ensure they are aligned with sales targets.

6. Utilities (Portion Related to Production Volume):

• Definition: Portion of the factory utilities (electricity, gas, water) directly related to production volume.
• Examples: Electricity used to power machinery, gas used for heating, water used in the manufacturing process.
• Calculation: Estimate the portion of utility costs that are directly related to production volume. This can be done by tracking utility usage during periods of high and low production.
• Tips: Implement energy-efficient technologies to reduce utility consumption. Monitor utility bills to identify potential cost savings.

7. Supplies:

• Definition: Cost of supplies used in the production process.
• Examples: Cleaning supplies, lubricants, safety equipment.
• Calculation: Track the quantity of supplies used and multiply by the cost per unit.
• Tips: Implement a system for managing and tracking supplies. Negotiate favorable pricing with suppliers.

Examples of Calculating Variable COGS

Let's illustrate the calculation of variable COGS with a few examples:

Example 1: Manufacturing Company

A manufacturing company produces widgets. Here's a breakdown of their costs:

• Raw materials: $10 per widget
• Direct labor: $5 per widget
• Packaging costs: $1 per widget
• Fixed overhead costs: $10,000 per month
• Units produced and sold: 1,000 widgets

To calculate the variable COGS:

• Raw materials: $10 x 1,000 = $10,000
• Direct labor: $5 x 1,000 = $5,000
• Packaging costs: $1 x 1,000 = $1,000

Total Variable COGS = $10,000 + $5,000 + $1,000 = $16,000

Variable COGS per unit = $16,000 / 1,000 = $16

Example 2: Retail Company

A retail company sells clothing. Here's a breakdown of their costs:

• Cost of goods purchased: $20 per item
• Shipping costs (directly tied to sales): $2 per item
• Sales commissions: 5% of sales revenue
• Fixed operating expenses: $5,000 per month
• Items sold: 500
• Sales revenue: $30,000

To calculate the variable COGS:

• Cost of goods purchased: $20 x 500 = $10,000
• Shipping costs: $2 x 500 = $1,000
• Sales commissions: 5% x $30,000 = $1,500

Total Variable COGS = $10,000 + $1,000 + $1,500 = $12,500

Variable COGS per unit = $12,500 / 500 = $25

Common Mistakes to Avoid When Calculating Variable COGS

Calculating variable COGS can be complex, and it's easy to make mistakes. Here are some common errors to avoid:

• Misclassifying Costs: Incorrectly classifying costs as variable or fixed can lead to inaccurate calculations.
• Omitting Costs: Forgetting to include all relevant variable costs can understate the variable COGS.
• Using Inaccurate Data: Using inaccurate or outdated data can result in unreliable calculations.
• Ignoring Inventory Changes: Failing to account for changes in inventory levels can distort the variable COGS.
• Not Verifying Calculations: Not verifying the accuracy of your calculations can lead to errors and misinterpretations.

The Importance of Technology in Managing Variable COGS

In today's digital age, technology plays a crucial role in managing variable COGS. Here are some ways technology can help:

• Accounting Software: Accounting software like QuickBooks, Xero, and NetSuite can automate the process of tracking and calculating variable COGS.
• Inventory Management Systems: Inventory management systems can help you track raw material usage and inventory levels in real-time.
• Time Tracking Software: Time tracking software can accurately record direct labor hours and associated costs.
• Data Analytics Tools: Data analytics tools can help you analyze cost data and identify trends and opportunities for cost reduction.
• Enterprise Resource Planning (ERP) Systems: ERP systems integrate all aspects of your business, including accounting, inventory management, and production planning, providing a comprehensive view of your cost structure.

Advanced Strategies for Reducing Variable COGS

Once you have a good understanding of your variable COGS, you can start implementing strategies to reduce these costs and improve profitability. Here are some advanced strategies to consider:

• Negotiate with Suppliers: Negotiate favorable pricing and payment terms with your suppliers to reduce raw material costs.
• Optimize Production Processes: Streamline your production processes to improve efficiency and reduce waste.
• Implement Lean Manufacturing Principles: Apply lean manufacturing principles to eliminate waste and improve productivity.
• Invest in Automation: Automate repetitive tasks to reduce direct labor costs.
• Improve Inventory Management: Optimize inventory levels to reduce storage costs and minimize the risk of obsolescence.
• Reduce Packaging Costs: Explore different packaging options to find the most cost-effective solution.
• Negotiate Shipping Rates: Negotiate shipping rates with carriers to reduce transportation costs.
• Improve Energy Efficiency: Implement energy-efficient technologies to reduce utility consumption.

FAQ About Variable Cost of Goods Sold

• What is the difference between variable COGS and total COGS?

  Variable COGS includes only the costs that vary with production volume, while total COGS includes both variable and fixed costs.

• How often should I calculate variable COGS?

  You should calculate variable COGS at least monthly, or more frequently if your business experiences significant fluctuations in production volume.

• Is depreciation included in variable COGS?

  Depreciation is typically considered a fixed cost and is not included in variable COGS.

• How can I use variable COGS to improve my business's profitability?

  By understanding your variable COGS, you can identify areas where you can reduce costs, improve efficiency, and increase profitability.

• What are some examples of fixed costs that are not included in variable COGS?

  Examples of fixed costs include rent, salaries, insurance, and depreciation.

• Can variable COGS be negative?

  No, variable COGS cannot be negative. It represents the cost of producing or selling goods, which cannot be a negative value.

• Is it possible for a cost to be both variable and fixed?

  Yes, some costs can have both a variable and a fixed component. These are called semi-variable costs. For example, a utility bill might have a fixed monthly charge plus a variable charge based on usage.

• How does variable COGS affect my business's break-even point?

  Variable COGS is a key input in break-even analysis. The higher your variable COGS, the higher your break-even point will be.

• What is the impact of inflation on variable COGS?

  Inflation can increase the cost of raw materials, direct labor, and other variable costs, which can lead to an increase in variable COGS.

• How does technology impact variable COGS?

  Technology can help businesses track and manage variable costs more efficiently, identify opportunities for cost reduction, and automate processes to reduce labor costs.

Conclusion

Finding the variable cost of goods sold is a critical step in understanding your business's profitability and making informed decisions. By accurately identifying, classifying, and calculating variable COGS, you can gain valuable insights into your cost structure, set competitive prices, and optimize your operations for maximum profitability. This article has provided a comprehensive guide to calculating variable COGS, including a step-by-step approach, detailed explanations of key components, and practical examples. By following these guidelines and avoiding common mistakes, you can master this essential accounting skill and improve your business's financial performance. Remember to leverage technology to streamline the process and continuously look for opportunities to reduce variable COGS and increase profitability.