Preface: Perception of variable costs can infuse greater financial control when pricing products and therefore improve profitability.

Read further for the powerful rudiments of the methodology. 

 

Perception of Your Businesses Variable Costs Can Improve Financial Performance

Typically most businesses cost production of units with the absorption costing method. Absorption costing simply includes standard manufacturing costs with product costs and inventory. Say for instance you absorb fixed manufacturing overhead (rent, insurance, management, purchasing, and heat) into cost of goods sold. With this method you will have an accurate financial metric of your complete costs; but that is not to say that they are specific expenses to the output of that product. Absorption costing methodologies help you calculate that for every $100 of inventory sold, your gross profit is $20 or say $45 dollars. Then your selling, general and administrative expenses are deducted from the gross profit to obtain net income.

Variable costing or say yield based pricing is for the strategic financial manager. Variable costing is just what is says, costing the variable expenses in say production. Variable costs include direct materials applied to manufacturing product, direct labor of shop floor employees involved in production, and variable overhead such as depreciation on equipment or utilities. Variable costing helps you adjust standard costings per product to period costs. Now understand that this can skew your true all-in cost of production that absorption costing includes; but nevertheless variable costing is still often helpful in management decision making. Why? Well, first your fixed costs of manufacturing overhead (rent, insurance, management, purchasing, and heat) will be incurred whether you produce 500 or 1,500 units. Revenue must be obtained to cover those fixed costs to keep a business cash flow positive.

Let’s say that a company can produce 100 or 100,000 units  with direct materials cost of $35, direct labor of $25, and variable cost $10. Let’s say with the full absorption method your factory overhead is $1,500 or $1,500,000; in this instance that factory overhead is $15 per unit. When you add up the variable costs ($35 direct material, $25 direct labor and $10 variable production overhead) you get $70 of variable cost per unit. Your fixed factory overhead, selling, general and administrative costs will be the same producing 90 or 110 units.

Variable Costing or Yield Based Pricing Benefits Exemplified

Using the above example, if you get an order for 20 or 20,000 additional units of production for a bid of $100, absorption costing may indicate a breakeven when calculating the all-in cost with selling, general and administrative expenses, when in reality, the variable cost would be only $70. You could add $30 per unit to your gross profit on the sale if fixed factory costs are already paid. The additional sale at the discount price would be more gross profit for your business.

Understanding variable costs or yield based pricing can benefit most any business. For instance if your business employs service technicians you have fixed and variable costs. Understanding variable costs will permit you to be more competitive with bidding to specific market segments if business revenue streams slow; or if you’re in a manufacturing industry, you will understand how you can discount product prices to maintain positive cash flow. Say if you’re a restaurant, understanding variable costs for yield based pricing and advertising entrée specials, promotions, or smorgasbord discounts, can result in keeping cash flow positive, tables filled, and maybe lead to more net income.

Variable costing or yield based pricing should always be defined with certain production goals, tables served, or billable hours. Specific delineation of costs can help you make more informed business decision when pricing your product or services. Talk to your CFO or call your accountant or CPA to discuss how delineating variable costs and yield based pricing can help you make more informed financial decisions for your business and improve financial performance.