What is a Semi-Variable Cost in Business? Definition, Formula and Examples
Semi-Variable Cost Definition
A semi-variable cost is an expense that has both fixed and variable components.
This means that part of the cost remains constant regardless of the level of activity (ie units produced), while the other part changes in line with the level of activity.
Let’s break down both components in more detail:
Fixed Component
This is the portion of the cost that remains constant, regardless of changes in business activity.
Examples of fixed costs would include:
- Base salary of employees
- Rent or lease payments
- Insurance premiums
- Equipment rental fees
- Loan payments
These costs are predictable and do not fluctuate with production levels.
Variable Component
This portion of the cost varies with the level of business activity.
These costs are directly proportional to the business’s output.
In other words, the more that a business produces or sells, the higher the cost becomes.
Examples of variable costs would include:
- Overtime wages
- Raw materials
- Sales commissions
- Packaging costs
- Bank transaction fees
These costs are unpredictable and fluctuate with production levels.
Semi-Variable Cost Graphs
Let’s enhance our understanding of semi-variable costs by visualising them with graphs
The x-axis represents the level of activity and the y-axis represents the total cost.
Fixed costs are shown as a straight horizontal line, as they do not change with activity levels.
Variable costs show a straight line that starts at the origin and slopes upwards, which shows that costs increase directly with production.
Semi-variable costs start above the origin, reflecting the fixed component, and slope upward to reflect the variable component.
Semi-Variable Cost Formula
The formula to calculate semi-variable costs is:
Semi-variable cost = Fixed cost + (Variable cost per unit × Number of units)
Let’s now use the formula to run through an example calculation.
Imagine a business that manufactures and delivers products.
The delivery truck is leased for £500 per month as a fixed cost (whether the truck is used or not).
Additionally, it costs £2 per mile driven, which is the variable cost.
In the previous month, the truck drives 500 miles.
Therefore:
Fixed cost | £500 |
Variable cost per mile | £2 |
Number of miles | 500 |
Using the semi-variable cost formula:
Semi-variable cost = Fixed cost + (Variable cost per unit × Number of units)
Semi-variable cost = £500 + (£2 × 500)
Total semi-variable cost for the month = £1,500
Real-World Examples of Semi-Variable Costs
Let’s now look at some real world examples of semi-variable costs in business:
Sales Commission
A sales team would typically receive a base salary plus a commission for each sale they make.
The base salary is a fixed cost (as it doesn’t change with the number of sales), while the commission is a variable cost (as it depends on the number of sales made).
Telephone Bills
The company might pay a fixed monthly charge for their phone line, but the total bill might also include variable costs based on the number of calls made or data used.
The fixed charge remains constant every month, while the variable part fluctuates based on usage.
Vehicle Expenses
A company vehicle might have a fixed cost for insurance and road taxes, while fuel and maintenance costs vary depending on usage.
The more the vehicle is driven, the more fuel is needed and the higher the likelihood that the vehicle may need repairs and maintenance.
Utility Costs
A company might pay a fixed rate to keep their manufacturing facility connected to the electricity grid, but the cost might increase with the amount of electricity used during production.
Equipment Maintenance Costs
A factory might incur a fixed maintenance cost to keep machines operational, regardless of production levels.
However, if production increases, additional maintenance might be required, leading to higher costs.
Importance of Semi-Variable Costs
Understanding semi-variable costs is extremely important for a business for several reasons:
Pricing
Knowing the semi-variable nature of certain costs can influence pricing strategies.
For example, businesses might set prices to cover fixed costs first, with the variable component being covered as sales increase.
Cost Control
By identifying the fixed and variable components of a cost, businesses can better control expenses.
For example, knowing that a portion of a cost is fixed helps in budgeting, while understanding the variable component helps in forecasting costs as production levels change.
Break-Even Analysis
Semi-variable costs play a key role in break-even analysis, where businesses determine the level of sales needed to cover all costs.
By separating fixed and variable components, companies can more accurately calculate the break-even point.
Profitability Analysis
By reviewing semi-variable costs, businesses can understand how changes in production levels will affect profitability.
For example, if the variable component of a semi-variable cost is high, increasing production could significantly increase total costs, impacting profits.
How to Manage Semi-Variable Costs
To manage semi-variable costs effectively, businesses can use a variety of strategies:
Cost Analysis
Semi-variable costs should be regularly analysed and monitored to understand their behaviours.
This involves tracking both the fixed (constant) and variable (fluctuating) components over time to identify patterns, cost drivers, and how changes in business activities influence these costs.
For example, a company with a fleet of delivery trucks may have a fixed cost for vehicle leases but variable fuel expenses based on miles driven.
By analysing fuel costs in relation to mileage each month, the company can better predict and control transportation expenses.
Break-Even Analysis
Conducting a break-even analysis helps businesses determine the point at which total revenues cover all fixed and variable costs.
For semi-variable costs, understanding this point enables businesses to set appropriate sales targets and pricing strategies that ensure profitability.
For example, a retail business with semi-variable labour costs (a base salary plus overtime based on sales) could use a break-even analysis to determine how many units of a product need to be sold to cover both the base salary and overtime wages.
Activity-Based Costing (ABC)
Activity-based costing (ABC) allocates costs to specific activities, providing a more accurate understanding of cost drivers.
For example, a manufacturing company could use ABC to allocate costs related to machine maintenance.
The fixed portion of maintenance (routine checks) is assigned based on time, while the variable portion (repairs) is allocated based on machine usage, which fluctuates with production volume.
Challenges in Managing Semi-Variable Costs
While understanding semi-variable costs is beneficial to a business, managing them can be challenging for several reasons:
Separation of Fixed Costs and Variable Costs
It can be difficult to accurately separate the fixed and variable components of a cost.
The fixed portion is usually fairly easy to identify, as it remains constant regardless of business activity.
However, the variable portion can be more obscure, especially if it fluctuates in ways that aren’t directly tied to production volume.
Budgeting
Due to the difficulty in separating fixed and variable costs, budgeting for semi-variable costs can be challenging.
Since these costs fluctuate with business activity, predicting them accurately needs a careful balance between analysing historical data and anticipating future changes.
External Factors
External factors out of the company’s control can also impact the variable component of semi-variable costs.
These can include changes in market demand, economic conditions, or regulatory shifts that affect the price or availability of resources.