The Difference Between Fixed Cost and Variable Cost

The Difference Between Fixed Cost and Variable Cost

variable cost

It is important to understand the behavior of the different types of expenses as production or sales volume increases. Total fixed costs remain unchanged as volume increases, while fixed costs per unit decline. For example, if a bicycle business had total fixed costs of $1,000 and only produced one bike, then the full $1,000 in fixed costs must be applied to that bike. On the other hand, if the same business produced 10 bikes, then the fixed costs per unit decline to $100.

Although fixed costs do not vary with changes in production or sales volume, they may change over time. Some fixed costs are incurred at the discretion of a company’s management, such as advertising and promotional expense, while others are not. It is important to remember that all non-discretionary fixed costs will be incurred even if production or sales volume falls to zero.

How are direct costs and variable costs different?

Economists reckon fixed cost as an entry barrier for new entrepreneurs. In accounting, variable costs are costs that vary with production volume or business activity. Variable costs go up when a production company increases output and decrease when the company slows production.

In most cases, increasing production will make each additional unit more profitable. This is because fixed costs are now being spread thinner across a larger production volume. For example, if a business that produces 500,000 units per years spends $50,000 per year in rent, rent costs are allocated to each unit at $0.10 per unit. If production doubles, rent is now allocated at only $0.05 per unit, leaving more room for profit on each sale.

Variable Cost

Total variable costs increase proportionately as volume increases, while variable costs per unit remain unchanged. For example, if the bicycle company incurred variable costs of $200 per unit, total variable costs would be $200 if only one bike was produced and $2,000 if 10 bikes were produced. However, variable costs applied per unit would be $200 for both the first and the tenth bike. The company’s total costs are a combination of the fixed and variable costs. If the bicycle company produced 10 bikes, its total costs would be $1,000 fixed plus $2,000 variable equals $3,000, or $300 per unit.

Variable costs are in contrast to fixed costs, which remain relatively constant regardless of the company’s level of production or business activity. Combined, a company’s fixed costs and variable costs comprise the total cost of production.

What is a variable cost example?

A variable cost is a corporate expense that changes in proportion to production output. Variable costs increase or decrease depending on a company’s production volume; they rise as production increases and fall as production decreases. Examples of variable costs include the costs of raw materials and packaging.

Fixed costs are those that will remain constant even when production volume changes. Whether you produce 1 unit or 10,000, these costs will be about the same each month. For example, raw materials, packaging and shipping, and workers’ wages are all variable costs.

Although total fixed costs are constant, the fixed cost per unit changes with the number of units. In business planning and management accounting, usage of the terms fixed costs, variable costs and others will often differ from usage in economics, and may depend on the context. Some cost accounting practices such as activity-based costing will allocate fixed costs to business activities for profitability measures.

Variable Cost Examples

This will give you an idea of how much of costs are variable costs. You can then compare this figure to historical variable cost data to track variable cost per units increases or decreases.

  • It is important to understand the behavior of the different types of expenses as production or sales volume increases.

Economies of scale are possible because in most production operations the fixed costs are not related to production volume; variable costs are. Large production runs therefore “absorb” more of the fixed costs. Setting up the run requires burning a plate after a photographic process, mounting the plate on the printing press, adjusting ink flow, and running five or six pages to make sure everything is correctly set up. The cost of setting up will be the same whether the printer produces one copy or 10,000.

This can simplify decision-making, but can be confusing and controversial. Under full (absorption) costing fixed costs will be included in both the cost of goods sold and in the operating expenses. The implicit assumption required to make the equivalence between the accounting and economics terminology is that the accounting period is equal to the period in which fixed costs do not vary in relation to production. In management accounting, fixed costs are defined as expenses that do not change as a function of the activity of a business, within the relevant period. For example, a retailer must pay rent and utility bills irrespective of sales.

The total expenses incurred by any business consist of fixed costs and variable costs. Fixed costs are expenses that remain the same regardless of production output. Whether a firm makes sales or not, it must pay its fixed costs, as these costs are independent of output. Economies of scale are another area of business that can only be understood within the framework of fixed and variable expenses.

If the set-up cost is $55 and the printer produces 500 copies, each copy will carry 11 cents worth of the setup cost-;the fixed costs. But if 10,000 pages are printed, each page carries only 0.55 cents of set-up cost. Variable costs are costs that change as the quantity of the good or service that a business produces changes. Variable costs are the sum of marginal costs over all units produced.

variable cost

In marketing, it is necessary to know how costs divide between variable and fixed costs. This distinction is crucial in forecasting the earnings generated by various changes in unit sales and thus the financial impact of proposed marketing campaigns. In a survey of nearly 200 senior marketing managers, 60 percent responded that they found the “variable and fixed costs” metric very useful. If the cost object is a product being manufactured, it is likely that direct materials are a variable cost. (If one pound of material is used for each unit, then this direct cost is variable.) However, the product’s indirect manufacturing costs are likely a combination of fixed costs and variable costs.

For example, a company may pay a sales person a monthly salary (a fixed cost) plus a percentage commission for every unit sold above a certain level (a variable cost). In economics, fixed costs, indirect costs or overheads are business expenses that are not dependent on the level of goods or services produced by the business. They tend to be time-related, such as interest or rents being paid per month, and are often referred to as overhead costs. This is in contrast to variable costs, which are volume-related (and are paid per quantity produced) and unknown at the beginning of the accounting year. On the other hand, the wage costs of the bakery are variable, as the bakery will have to hire more workers if the production of bread increases.

Fixed costs and variable costs make up the two components of total cost. Direct costs are costs that can easily be associated with a particular cost object. For example, variable manufacturing overhead costs are variable costs that are indirect costs, not direct costs.

Tracking variable costs is useful for managers who want to document where company money goes, and also is useful for calculating break-even sales volume and for evaluating pricing levels. Break-even sales volume is the number of units a firm must sell to exactly cover total operating costs. Subtract the variable cost per unit of $15 from the $40 price, leaving $25. Divide fixed costs by $25 and you have a breakeven sales volume of 28,000 units. If the company doesn’t expect to sell enough additional units to provide an adequate profit, management will want to re-evaluate the pricing strategy, company sales goals or both.

Variable Cost Explained in 200 Words (& How to Calculate It)

variable cost

Variable costs are sometimes called unit-level costs as they vary with the number of units produced. The graphs for the fixed cost per unit and variable cost per unit look exactly opposite the total fixed costs and total variable costs graphs.