What is a ‘Variable Overhead’
Variable overhead is the indirect cost of operating a business, which fluctuates with manufacturing activity. For example, while most overhead costs, such as rent, salaries and insurance, are typically fixed, expenses paid to utilities for electric power, gas and water tend to vary depending on the rollout of new products, manufacturing cycles for existing products and seasonal patterns. Additional factors that may be included in variable overhead expenses are materials, changes in the labor force and maintenance of equipment.
Explaining ‘Variable Overhead’
Manufacturers must include variable overhead expenses to calculate the total cost of production at current levels, as well as the total overhead required to increase manufacturing output in the future. The calculations can then be applied to determine the minimum price levels for products to ensure profitability. For example, a manufacturing facility can experience a wide range in monthly expenses for electricity, ranging from keeping the lights on to maintaining triple production shifts. Because months without production are still a manufacturing-related expense, the variable overhead expenses must be included in the calculation of the cost per unit to ensure accurate pricing.
Fixed, Direct and Variable Overhead
The fixed costs of a manufacturing facility include lease or mortgage payments, salaries for permanent employees, benefits and insurance. Direct costs include only the labor and materials directly involved in the manufacturing process. The rest of the expenses related to manufacturing are categorized as being indirect costs. As production increases, indirect expenses are also expected to increase, with the potential of being offset to a degree by economies of scale. Examples of increasing indirect costs include additional labor required for quality assurance, hiring staff for phone and e-commerce sales, and shipping and handling goods.
Variable Overhead and Pricing
Increasing production generally increases the total expense of variable overhead, but increased efficiencies and price discounts for larger orders of materials can lower the direct cost per unit. A company with a cost of $1 per unit in production runs of 10,000 might see a decline in the direct cost to 75 cents if the manufacturing rate is increased to 30,000 units. If the manufacturer maintains selling prices at the existing level, the cost reduction of 25 cents per unit represents $2,500 in savings on each production run. In this example, as long as the total increase in the indirect costs such as utilities and supplemental labor is less than $2,500, the company can maintain its prices, potentially triple its sales and expand its profit margin.
Further Reading
- Regulations, market structure, institutions, and the cost of financial intermediation – www.nber.org [PDF]
- Indicator variables model of firm's size-profitability relationship of electrical contractors using financial and economic data – ascelibrary.org [PDF]
- The principal factors affecting construction project overhead expenses: an exploratory factor analysis approach – www.tandfonline.com [PDF]
- SME finance in Africa – academic.oup.com [PDF]
- How financial sector and social overhead capital determine GDP growth – www.um.edu.mt [PDF]
