Fixed and Variable Costs

 What are Fixed and Variable Costs?

Cost refers to the money spent on producing goods or providing services, representing the value that can no longer be used. The pricing of a product is influenced by its cost, with profit added to the production cost to determine the selling price.

Fixed costs stay the same, regardless of how much or how little a business produces. On the other hand, variable costs rise and fall depending on the volume of production.

In accounting, costs encompass the monetary value of expenditures on supplies, services, labor, products, equipment, and other items necessary for business operations. These costs are recorded in bookkeeping as expenses or assets.

There are various types of costs, including:

• Accounting cost: The amount denoted on invoices, recorded in bookkeeping as an expense or asset cost basis.
• Marginal cost: The additional cost incurred by producing one more unit of a product.
• Sunk cost: Costs that have already been incurred and cannot be recovered.
• Fixed cost: Expenses that remain constant regardless of the level of production or sales.
• Variable cost: Expenses that fluctuate based on the level of production or sales.

What Are Variable Costs?

Variable or Prime costs refer to any cost or amount that a company has to bear concerning the quantity or volume of goods or services produced by them. In simple terms, the variable costs depend on the company's production.

If a company produces more goods or services, the variable cost will be higher, and if the quantity produced is decreased, the variable cost will also decrease. 

Here are a few examples of Variable costs:

• Direct labor: The wages paid to the laborers as per the production done by them. The total labor depends on the total production.
• Commission: This is a certain type of bonus given to the salesman for the number of units sold by them. If the sold units are higher, the commission will also be higher, and vice versa.
• Packaging: The product has to go through 2 main types of packaging, namely Primary, and Secondary. In both cases, the amount is dependent on the level of production.
• Delivery expenses: The cost required to deliver a product to the wholesaler, retailer, or consumer is also related to the quantity produced.
• Cost of material: Raw material is required to produce finished goods, and the volume of goods produced influences the cost of the material.

These costs can be simply multiplied by the quantity of production to derive the total value. 

For example, suppose the labor is $3 per unit, and the company is producing 100 units in a day. In that case, the variable cost will be $300. 

If the same company is incurring delivery expenses of $2 per unit, the Total variable cost will be:

$300 + $200 = $500

When a comparison of two companies' costs is to be done, one must see to it that the companies being compared are in the same industry. 

An automobile company’s cost cannot be compared to an IT company’s cost as both these companies have different lines of working and operating.

What are Fixed Costs?

Unlike Prime costs, fixed costs are the costs that remain constant regardless of the quantity or amount of goods or services produced by the company. Therefore, the company has to pay a fixed amount even if there is 0 production.

Some common fixed costs are:

• Rent: Rent is a fixed payment that has to be made irrespective of the production volume
• Depreciation cost: This is a value deduction of an asset because it is due to the wear and tear of the asset.
• Bank charges: These are the charges payable for opening and maintaining a bank account.
• Interest: When money is borrowed from a third party, a certain amount is payable to the third party as interest.
• Insurance: This is a type of security that a company has purchased by paying a certain sum of money at regular intervals for protection against losses. 
• Tax: Every country has its taxation principles; this is the payment to the government for the money earned.
• Utility expenses: The expenses accrued for using various utilities like electricity, water, telephone, fuel, internet, etc.

These costs also change at specific times, such as if the contract of the rent has to be renewed and the owner increases the rent or when the Government increases the tax for a certain material. 

Suppose a car manufacturing company has leased a painting machine for painting the car's body at $10000 per month, irrespective of the number of car bodies painted. In that case, the company is liable to pay $10000 per month to whom the machine is leased from. 

Even though the cost is not directly related to production, it indirectly has an effect due to production. 

Let us understand it through this demonstration. As per the above example of a car manufacturing company, if the painted cars are 10, the fixed cost per car will be $1000.

If the painted cars are increased to 100, the cost per car will be $100.

Break-even Analysis

Break-even analysis is a type of study that the investors and management do to find out the number of units to be produced and sold to pay off all the fixed and variable expenses incurred for production. 

Break-even analysis is useful in determining the level of production or a targeted desired sales mix.

This helps in setting goals that are to be achieved for the company to earn profit and grow/expand. At the break-even point, the total sales are equal to the total cost of production.

This analysis helps the investors to learn and understand the company and decide whether to invest or not in the company.

Break-even analysis looks at the level of fixed costs relative to the profit earned by each additional unit produced and sold. Generally, a company with lower fixed costs will have a lower break-even point of sale. 

For example, a company with $0 of fixed costs will automatically have broken even upon the sale of the first product assuming variable costs do not exceed sales revenue.

You will not invest in a company that cannot pay off the basic expenses required to produce their product profit is another subject.

Variable Costs vs. Fixed Costs

Now let us look at the major differences between Fixed and Variable costs. 

Given below is a table that shows the same.

What is the Semi-variable cost?

These costs are a mixture of both costs. Some part of the total cost is fixed, while a certain part depends on the production. They include parts of both variables as well as fixed costs.

It is important for the company to identify and distinguish between the two to help determine price and control or cut costs, as it is advisable for a company to have more fixed costs over variable costs.

Let's take electricity, for example. Here a certain sum of money is fixed irrespective of consumption.  

If a company has two machines using electricity for production and out of the two, 1st machine consumes 200 units. The 2nd machine uses 300 units while the cost for 100 to 200 units is $3 per unit, and for units, more than 200 is $5 per unit. The total cost will be 3*200 + 5*300= $2100.

As seen above, the number of units consumed directly and indirectly affects the total cost of the product/service. 

As a certain part of the cost is variable, the management needs to distinguish between the two to analyze and predict the cost of the variable part to come to the estimated total cost of production.

Examples of fixed, variable, and semi-variable costs

Let's look at a couple of examples of the different types of costs. 

The first example is about how fixed and variable costs work. The second is on semi-variable cost functioning.

1. Examples of Fixed and Variable Costs

In the above chart, the total cost incurred by company A is shown as seen. The fixed costs, such as Rent and Interest, continue to remain constant irrespective of the volume of production. In contrast, Labor And Delivering expenses increase as the volume of production in the company increases.

The increase or decrease in the production volume directly affects the company's variable cost. 

Due to this phenomenon, a company has to identify and differentiate between the two costs to estimate the volume of production and derive an estimated cost of production that will help in the price determination of the product or service.

As the price of a product consists of two things: the cost of production and profit, the profit is added to the cost, and the selling price of the product is determined.

2. Example of semi-variable cost

If a company has no production of goods or services, it will still have to bear some expenses for running the company. All these expenses will be fixed expenses or semi-variable expenses. 

Where can Fixed and Variable costs be used?

The key reason why a company has to distinguish between the two costs is that a company has to prepare a statement of Cost of goods manufactured (COGM). 

With the help of this statement, the company can estimate the cost of producing a product in the company during a certain time. 

By classifying between fixed and variable costs, the company can conclude whether to stabilize the variable costs, which keep fluctuating, to a more stable fixed cost.  

If the company incurs high labor costs, investing in an asset will be preferable, but other factors, such as the output volume of production and sales during the period, must also be considered.

If the sales are low, investing in an asset will be of no use; rather, investing in advertising will be preferable.

This indicates that the costs also help identify and solve various company problems. Identifying the problem is said to solve half the problem

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources:

• Variable Costs
• Accounts Payable
• Variable Cost Ratio
• Depreciated Cost
• Inventoriable Costs