Variable Cost Ratio

Variable cost ratio is the ratio of variable costs to sales. It equals total variable costs divided by total sales or variable cost per unit divided by price per unit or 1 minus contribution margin ratio.

Variable costs are costs which change with a change in output, for example cost of raw materials, direct labor, variable manufacturing overheads, etc. The variable cost ratio tells us the percentage of each sale that is spent on incremental cost of production of the unit sold.

A high variable cost ratio means that a small portion of the sales revenue is available for fixed costs and profit. When the variable cost ratio is high, increase in sales results in slower increase in profit. Further, when the variable cost ratio is high, contribution margin ratio is low and breakeven point is high, and vice versa.

Formula

Following formulas can be used to calculate variable cost ratio:

$$\text{Variable Cost Ratio}\\ =\frac{\text{Total Variable Costs}}{\text{Total Sales}}\\=\ \frac{\text{Variable Cost per Unit}}{\text{Sales Price per Unit}}$$

Variable cost ratio can be used to find a product’s contribution margin ratio:

$$\text{Variable Cost Ratio}\ =\ \text{1}\ -\ \text{Contribution Margin Ratio}$$

Variable cost ratio is particularly useful in finding composite contribution margin ratio i.e. the weighted average contribution margin ratio of all the company’s products. Instead of finding contribution margin for each product and then obtaining its weighted average, we can work out variable cost ratio (because total variable costs are readily available) and find contribution margin ratio using the above formula.

Example

Rackets, Inc. produces tennis and squash rackets.

• 10,000 tennis rackets are sold per annum at $200 per unit. Variable cost per tennis racket is$150.
• Total revenue from squash rackets is $600,000 per year.$400,000 is spent on materials and labor.

Let’s work out the company’s contribution margin ratio using variable cost ratio.

Solution

$$\text{Variable Cost Ratio}\ (\text{Tennis})=\frac{\text{\150}}{\text{\200}}=\text{75%}$$

$$\text{Variable Cost Ratio}\ (\text{Squash})=\frac{\text{\400,000}}{\text{\600,000}}=\text{67%}$$

Since contribution margin ratio equals 1 – variable cost ratio, contribution margin of tennis racket is 25% and that of squash racket is 33%.

$$\text{Composite Variable Cost Ratio}=\frac{\text{10,000}\times\text{\150}+\text{\400,000}}{\text{10,000}\times\text{\200}+\text{\600,000}}=\text{73%}$$

$$\text{Composite Contribution Margin Ratio}\ =\ \text{1}\ -\ \text{73%}\ =\ \text{27%}$$

by Obaidullah Jan, ACA, CFA and last modified on

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