In economics, fixed costs and variable costs are two of the primary ways a company will incur costs for producing goods. All operating businesses incur costs, whether it is a service provider or retail business. Fixed costs and variable sound quite similar, however, there is a difference between the two. This article will help to give you a breakdown of the two and show some examples of both.
What Is a Fixed Cost?
A fixed cost is an expense that will remain the same even if there is an increase or decrease in production volume. Fixed costs are paid by companies no matter the amount of business they have.
For example, rent prices will remain the same regardless of how much business you have that month. Another example is insurance, again it will stay the same even if production rates fluctuate.
Key points for fixed costs:
- Fixed costs stay the same no matter the levels of production output.
- Fixed costs may include insurance, interest payments and lease and rental payments.
What Is A Variable Cost?
A variable cost is an expense that can change based on production output levels. The variable costs will increase or decrease dependant on the volume of production.
The variable cost will rise if there is an increase in production rates and the variable cost will fall when there is a decrease in production rates. For example, the higher the cost of packaging and raw materials when production increases. The same goes for if production levels decrease, the lower the cost of packaging and raw materials.
Key points for variable costs:
- Variable costs change depending on the volume of output produced.
- Variable costs may include commissions, raw materials and labour costs.
Examples of Fixed Costs And Variable Costs
|Fixed Costs||Variable Costs|
|Property rent: Property rent remains the same each month, unless you change location or negotiate new prices. Usually, your rent will stay at the same amount for the lifespan of your time there.||Shipping costs: By selling and producing more products, you’ll have to pay more for shipping fees. These costs will also decrease if you sell less products than normal.|
|Insurance costs: Insurance costs such as property insurance and healthcare insurance for staff will usually stay the same price.||Labor costs: If you see a rise in sales and need to produce more products, you may find a need to hire more staff to keep up with demands.|
|Manufacturing equipment: Renting equipment or buying equipment will come at a fixed cost, even though monthly payments.||Raw materials: Selling more products means you’ll need more raw materials to produce the products. The same applies to a decrease in sales.|
|Permits and licenses: Permits and license fees that companies pay will be fixed fees and won’t change based on production levels.||Sales commissions: If your employees receive a sales commissions, then costs will increase if they make more sales, the opposite if sales fall.|
|Fixed utility bills: Usually, gas, water, electricity, internet and utility bills will stay the same all year round, with some changing slightly. They stay the same no matter how much energy you use and if production increases or decreases.||Variable utility bills: There are utility contracts that are affected by fluctuating production levels. This occurs when producing more goods, the energy bills will be higher than normal. However, when producing less energy, your bills will decrease. These are good for seasonal businesses.|
What Is the Difference Between Fixed Cost and Variable Cost?
|Fixed Costs||Variable Costs|
|Definition||Fixed costs are expenses that will remain the same for a period of time, no matter of the number of outputs.||Variable costs are expenses that will change in proportion to any changes in business volume or activity level.|
|Occurs When||Fixed costs are incurred, even if the output remains nil.||Variable costs increase or decrease depending on the output.|
|Other Names||Period costs, overhead costs or supplementary costs.||Direct costs or prime costs.|
|Nature||Time-related as they stay the same for a period of time.||Volume-related as they fluctuate with changes in output level.|
|Some Examples||Salary, interest rates, property taxes, insurance costs.||Fuel, clothing prices and public transportation costs.|
|What Happens When Production Increases?||Total variable costs will increase.||Total fixed cost will stay the same.|
|What Happens When Production Decreases?||Total variable costs will decrease.||Total fixed cost will stay the same.|
Real-Life Example A: Fixed vs. Variable Costs In Manufacturing
The table below shows various example costs for a manufacturing company:
|Staff life insurance||x|
|Metal used in manufacturing.||x|
|Electricity used in manufacturing products.||x|
|Depreciation of machine value.||x|
Real-Life Example B: Fixed and Variable Costs For An Energy Supplier
For our example, an energy company supplies gas and to deliver the gas, it costs £100 per month to supply one house. The company pays £20,000 in rental costs for using their office.
Here is the breakdown of the company’s spending based on their production levels.
|Number Of Homes Supplied||Variable Cost per Home Supplied per Month||Total Variable Cost||Total Fixed Cost|
How Do I Calculate Fixed Costs?
Fixed costs can be calculated easily without much hassle. A simple way is to add up all your fixed costs to get your total fixed costs.
Another way is to calculate your production costs by adding them all up, making sure to separate fixed costs and not variable costs. Then using the total production costs, take away your variable costs and then multiply by the number of units produced. This gives you the total fixed cost.
Here is the formula that you can use to get the fixed cost:
Total production costs – (Variable cost per unit x Number of units produced) = Fixed costs
How Do I Calculate Variable Costs?
Calculating Total Variable Cost
The sum of the variable cost per each item produced makes the total variable cost. To calculate the total variable cost, you multiply the cost per unit of the product by the number of products you produce.
Cost For One Product x Number Of Products Made = Total Variable Cost (TVC)
Calculating Average Variable Cost
The average variable cost takes the total variable cost of a product to find the average cost it takes to make one unit of a product. It can be useful for a company to get an idea of how much the average cost is per item.
TVC Of Product 1 x TVC Of Product 2 (multiply as many products as you need) / Total Number Of Products Made = Average Variable Cost (AVC)
Why Is It Important to Distinguish Between Fixed Costs and Variable Costs?
If you are an owner of a small business, keeping track of expenses and changes to costs is important. Changes in expenses can come from fluctuations in output levels depending on how well your business is doing and how many sales you’re making.
Looking at these expenses, you can get an idea of how much you will be paying each month based on production output and can influence your business strategy and other aspects of your company.
The main thing to think about is costing, such as staffing. Depending on production rates, some costing methods might be more cost-effective, such as employing staff based on job orders.
Variable and fixed costs are the primary ingredients to costing methods that businesses use, such as activity-based costing, process costing and job order costing.
What Are Fixed And Variable Salaries?
Employees who earn the same amount no matter how well their business is doing is on a fixed salary. Employees who work per hour and work based on hours that the company needs are on a variable salary.
Employees that work based on piecework labour, such as working on a specific number of items are on a variable salary. The same applies to employees who work dependant on sales commissions. If an employee is paid a set salary, plus earns commissions on sales, then they will be on both a fixed and variable salary.
What Is Break-Even Analysis?
When wanting to make a profitable business, knowing your fixed and variable expenses is crucial for striving towards that goal. Break-even analysis is a great way to weight up between fixed and variable costs to identify costs. This is done by the following formula:
Fixed costs / (Price – Variable costs) = Volume required for breaking even.
This formula gives you key data for pricing and it can also be modified for estimated expansions in the future. If you’re considering acquiring a business, you can get vital information about what profits are projected and ways you can improve them if you purchase the company. You can also obtain the number of units you need to make a profit and think about if these numbers are realistic and can be reached.
Using Fixed And Variable Costs For Economies Of Scale
Having a clear understanding of fixed and variable costs, you can use this information to find the economies of scale. When output rates increase, you’ll see fixed costs being spread over a higher amount of output items.
Both fixed and variable costs are used to give you a total understanding when looking at the overall cost structure of a business. Knowing the difference between the two is vital when weighing up decisions about expenses for business and how they can have an effect on profit levels.
Average Variable Cost vs Total Variable Cost
If you can find the average variable cost for one unit by using the total variable cost, then surely, we know how much it costs to produce one unit. However, you can be easily mistaken for thinking you can work backwards by dividing the total variable cost by the number of products I have.
The total variable cost will give you the cost you’re paying to produce each unit of a product, there are other products that will have different variable costs per unit. That is why we use the average variable cost.