Variable cost per unit is the cost associated with producing a good or service that changes frequently, and is used in manufacturing to incorporate raw material costs. It is used to determine the unit price of manufactured items and can be risky or profitable depending on market conditions. Potential investors are concerned about variable costs when considering profit margins.
Variable cost per unit (VC) is defined as the costs associated with producing a good or service that change frequently. In the business world, variable costs are most frequently used in manufacturing to incorporate raw material costs. Since most businesses rely partially on variable cost products, however, this concept can be found in the accounting of almost any organization.
In the manufacturing world, there are generally two types of costs involved in manufacturing. Fixed costs remain relatively constant regardless of the number of units produced; variable costs depend on the number of units produced. Facility costs and often labor costs are considered in determining the fixed cost of each unit. Raw materials, packaging costs and, to a lesser extent, utility costs are included in the variable cost per unit.
The primary function of VC valuation is to determine the unit price (UP) of manufactured items. This number is usually added to the company’s fixed costs in producing a certain number of units and then divided by the total number of items. The resulting number is the amount each unit would have to be sold for to break even. Usually, a percentage number is added to each unit to ensure profit. The final dollar amount is the selling price per unit.
Producing a product with a highly variable cost per unit can be risky. While some commodities, such as lumber, have historically ballooned at a fairly predictable rate, others are heavily dependent on market conditions. Sudden spikes in material costs can dramatically increase the cost of a product. In these cases, manufacturers may be forced to reduce profit margins or offer their product at a price that their customer base may not be able to afford.
Conversely, products with variable costs can be quite profitable. First, the prices of manufactured goods generally do not go down. Therefore, consumers don’t expect a company to cut its prices because raw materials are cheaper. Historically, when commodity markets are depressed, producers often report higher profit margins. Furthermore, careful accumulation of resources during these depressions can alleviate the financial impact of sudden increases in material costs.
Potential investors are often very concerned about the variable cost per unit when considering the profit margins of a particular business. Unlike standard business models, the true fiscal growth of manufacturing firms can be distorted by variable costs. Simply put, increased profits for these organizations don’t necessarily mean increased sales, nor does decreased profit margins mean the company is losing customers.
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