Important Differences Between Fixed Cost and Variable Cost

Fixed Cost

Fixed cost is a type of cost that does not change with the level of production or sales volume in the short run. In other words, fixed costs are expenses that a company has to pay regardless of how much it produces or sells.

Examples of fixed costs may include rent or lease payments, salaries and wages of permanent employees, insurance premiums, property taxes, and equipment depreciation. These costs are considered to be fixed because they do not vary with the level of output or sales volume.

It is important for businesses to consider fixed costs when making decisions about production, pricing, and sales volume, as these costs must be covered regardless of how much revenue is generated.

Fixed Cost Types

Committed Fixed Costs:

These are fixed costs that are essential to the ongoing operations of a business and cannot be easily reduced or eliminated in the short term. Examples include rent or lease payments for facilities, salaries and wages of permanent employees, and insurance premiums. These costs are typically contracted or committed to for a longer period of time and are often considered sunk costs.

Discretionary Fixed Costs:

These are fixed costs that can be adjusted or eliminated in the short term, depending on the needs of the business. Examples include advertising and marketing expenses, research and development costs, and office supplies. These costs are usually more flexible than committed fixed costs and can be reduced or eliminated to adjust to changes in business conditions.

Fixed Cost features

1. Does not change with production level: Fixed costs remain the same, regardless of the level of production or sales volume. This means that the cost per unit decreases as production increases, resulting in economies of scale.
2. Time frame: Fixed costs are typically associated with a specific time period, such as a month or a year. However, in the long term, some fixed costs can become variable costs if the company decides to expand or downsize its operations.
3. Depreciation: Some fixed costs, such as equipment and machinery, may depreciate over time, reducing their value and becoming a lower fixed cost over time.
4. Sunk costs: Fixed costs are often considered sunk costs, meaning they are already incurred and cannot be recovered. This means that businesses must cover their fixed costs regardless of the level of revenue generated.
5. Importance for decision making: Fixed costs are an important consideration for businesses when making decisions about pricing, production levels, and sales volume. Companies must generate enough revenue to cover their fixed costs, in addition to variable costs, in order to be profitable.

Variable Cost

Variable cost is a type of cost that changes in proportion to changes in production or sales volume. In other words, as production or sales increase, variable costs increase, and as production or sales decrease, variable costs decrease.

Examples of variable costs include raw materials, direct labor costs, sales commissions, packaging, and shipping costs. These costs are considered to be variable because they fluctuate with the level of output or sales volume.

Variable costs are important to businesses because they affect the profit margin of each unit sold. The higher the variable costs, the lower the profit margin per unit. Therefore, businesses must carefully manage their variable costs to ensure profitability.

Variable costs are also important in determining the breakeven point for a business. The breakeven point is the point at which the revenue generated equals the total costs, including both fixed and variable costs. By understanding the relationship between variable costs and production or sales volume, businesses can determine how much they need to sell in order to cover their costs and become profitable.

Variable Cost Types

Direct Variable Costs:

These are costs that are directly related to the production of a good or service. Examples include raw materials, direct labor costs, and packaging. Direct variable costs can be easily traced to a specific product or service.

Indirect Variable Costs:

These are costs that are indirectly related to the production of a good or service. Examples include sales commissions, shipping costs, and utilities. Indirect variable costs cannot be easily traced to a specific product or service and are often allocated to different products or services based on certain criteria.

Variable Cost Features

• Changes with production level: Variable costs change in direct proportion to changes in production or sales volume. As production or sales increase, variable costs increase, and as production or sales decrease, variable costs decrease.
• Time frame: Variable costs are typically associated with a specific time period, such as a month or a year. However, in the long term, some variable costs can become fixed costs if the company decides to expand or downsize its operations.
• Directly linked to output: Variable costs are directly linked to the production or sales of a product or service. This means that businesses can control variable costs by adjusting their production or sales volume.
• Importance for decision making: Variable costs are an important consideration for businesses when making decisions about pricing, production levels, and sales volume. By managing variable costs effectively, businesses can improve their profit margin and become more competitive in their market.
• Impact on breakeven point: Variable costs play a key role in determining the breakeven point for a business. By understanding the relationship between variable costs and production or sales volume, businesses can determine how much they need to sell in order to cover their costs and become profitable.

Fixed Cost and Variable Cost formula

Fixed Cost Formula:

Fixed costs are costs that do not change with changes in production output or sales volume. The formula for fixed cost is:

Fixed Cost = Total Cost – Total Variable Cost

where Total Cost is the total cost of production, and Total Variable Cost is the total cost of variable costs.

Variable Cost Formula:

Variable costs are costs that change in proportion to changes in production output or sales volume. The formula for variable cost is:

Variable Cost = Cost per Unit x Units of Production

where Cost per Unit is the variable cost per unit of production, and Units of Production is the number of units produced.

In some cases, variable costs may be expressed as a percentage of sales revenue. In this case, the formula for variable cost would be:

Variable Cost = Variable Cost Percentage x Sales Revenue

Where Variable Cost Percentage is the percentage of sales revenue that is allocated to variable costs.

Key Differences Between Fixed Cost and Variable Cost

Important Differences Between Fixed Cost and Variable Cost

Fixed costs and variable costs are two types of costs that businesses incur in their operations. Here are some important differences between fixed costs and variable costs:

1. Definition: Fixed costs are costs that do not change with changes in production output or sales volume, while variable costs are costs that change in proportion to changes in production output or sales volume.
2. Examples: Common examples of fixed costs include rent, salaries, insurance premiums, and property taxes. Examples of variable costs include raw materials, direct labor, commission payments, and utility bills.
3. Behavior: Fixed costs remain constant over time, regardless of changes in production output or sales volume, while variable costs increase or decrease in proportion to changes in production output or sales volume.
4. Impact on Break-even Point: Fixed costs increase the break-even point of a business, while variable costs decrease the break-even point of a business.
5. Control: Fixed costs are typically more difficult to control in the short term, while variable costs can be more easily controlled through short-term decisions.
6. Timeframe: Fixed costs are usually incurred over a long period of time, while variable costs are incurred in the short term.
7. Effect on Profit Margin: Fixed costs have a greater impact on profit margin when sales volume is low, while variable costs have a greater impact on profit margin when sales volume is high.
8. Type of Business: Fixed costs are more common in businesses with high initial investment costs, such as manufacturing or real estate, while variable costs are more common in businesses that are more labor-intensive or rely heavily on inventory, such as retail or hospitality.

Similarities Between Fixed Cost and Variable Cost

Fixed costs and variable costs are both types of expenses that a business incurs in the process of producing goods or services. Here are some similarities between the two:

• Both are associated with the production of goods or services: Fixed costs and variable costs are incurred in the process of producing goods or services. They are essential for the operations of a business.
• Both affect the profitability of a business: Fixed costs and variable costs both impact the profitability of a business. The total cost of production is the sum of fixed costs and variable costs, which affects the price of the product and the profit margin of the business.
• Both can be managed: A business can manage both fixed costs and variable costs to reduce expenses and increase profitability. For example, a business can negotiate lower prices for raw materials to reduce variable costs, or it can reduce rent expenses to lower fixed costs.
• Both can be planned for: A business can plan for both fixed costs and variable costs in its budgeting process. By accurately forecasting these costs, a business can better manage its cash flow and make more informed business decisions.
• Both are essential for calculating break-even point: Fixed costs and variable costs are both used to calculate the break-even point of a business. The break-even point is the level of sales at which the total revenue equals the total cost, and the business starts to make a profit.