A variable cost is an expense that rises or falls in conjunction with a company's level of productivity.
Let's say you make yidgets (too much competition in the widget game). How many vats of glue you buy to assemble your yidgets depends on how many orders you have. So this is -- ta-da -- a variable cost that varies with how active your business is. A fixed cost, in contrast, would be something like the rent you pay on your yidget factory. The landlord wants her money; no excuses.
Investors want their companies to have variable expenses appropriately in line with the ups and downs of their businesses. Glue sitting in the back of a factory that is making only half as many yidgets as it did last quarter could end up being a drag on the current quarter's balance sheet.
The percentage of total costs that are variable can also tell investors something about how the companies they own will be able to respond and profit as demand ebbs and flows. If a large portion of a company's operating costs are variable, that translates to ramp-up costs when demand increases. Funding for those ramp-up costs will come out of sales revenue, meaning smaller margin increases.
On the flip side there's a bit better news. If demand decreases, variable costs can be cut out of the budget relatively quickly. However, fixed costs such as property taxes and insurance continue even if the demand for yidgets tanks.
Variable costs are the costs of goods sold (COGS).
Related Fool Articles
Recent Mentions on Fool.com
- Can Enterprise Products' Earnings Change Investors' Perceptions?
- This Shocking Chart Will Redefine How You View Early Retirement
- Facebook's Q2: Upside Fuel or Time for a Pause?
- 2015 Social Security Trustees Report: The 3 Things You Should Know
- Are Gold Miners a Screaming Buy?
- MarketAxess Holdings Inc. Earnings: Share Gains Drive Profits 33% Higher