Definition: The variable cost ratio is a financial measurement that calculates dependent costs of production as a percentage of sales. In other words, it shows the relationship between net sales and variable production costs by comparing the net sales of the company with the costs that vary with the level of output.
What Does Variable Cost Ratio Mean?
Unlike fixed costs, like rent, VC changes as production levels change. Take parts for example. As production increases, the company will use more parts in the process. As production decreases, they will use fewer parts in the process. The rent expense will always stay the same however. This difference is important as management plans out production runs and develops a market strategy.
By measuring variable costs as a percentage of net sales, we can see what percentage of sales can be used to cover fixed costs and other operating expenditures. This concept helps management understand the cost structure of their production process and price their products accordingly.
The variable cost ratio formula is calculated by dividing the VC of production by the net sales. This can be calculated on a per unit basis or a production run basis.
Let’s look at an example.
Management of Prestige Paper Products holds annual meetings to assess revenues and the outlook of the company. One of the key metrics in management’s analysis is the VCR, so they can determine how much revenue is required to cover all variable and fixed costs. The main dependent costs for PPP are direct labor and paper materials. This year the company sold $100,000 of paper products with variable costs totaling $60,000.
Using the variable cost ratio equation (VC – Net Sales), management calculates a ratio of 60 percent. This means that for every dollar earned, $0.60 is used to cover the variable costs. Does this change as the production levels increase?
The answer is no. The ratio will stay the same if the company produces one unit or one hundred units because the VC will fluctuate accordingly. Management can use this as a planning tool for next year’s production runs, budget, and pricing policies.