Variable Costs vs. Fixed Costs: An Overview
Fixed costs are expenses that remain the same no matter how much a company produces, such as rent, property tax, insurance, and depreciation. Variable costs are any expenses that change based on how much a company produces and sells, such as labor, utility expenses, commissions, and raw materials.
Fixed costs are normally independent of a company's specific business activities. Variable costs increase as production rises and decrease as production falls. Understanding the difference between these costs can help a company ensure its fiscal solvency.
Key Takeaways
- Companies incur two types of production costs: variable and fixed costs.
- Variable costs change based on the amount of output produced.
- Variable costs may include labor, commissions, and raw materials.
- Fixed costs remain the same regardless of production output.
- Fixed costs may include lease and rental payments, insurance, and interest payments.
Variable Costs
Variable costs are any costs that a company incurs that are associated with the number of goods or services it produces. A company's variable costs increase and decrease with its production volume. When production volume goes up, the variable costs increase.
But if the volume goes down, the variable costs follow suit. If a company has a product line that is underperforming or outdated, it may choose to stop production of that line. The costs associated with this product are considered avoidable costs.
As noted above, examples of variable costs generally include:
- Labor
- Commissions
- Packaging
- Utility expenses
- Raw materials for production
Calculating variable costs can be done by multiplying the quantity of output by the variable cost per unit of output. Suppose ABC Company produces ceramic mugs for a cost of $2 per mug. If the company produces 500 units, its variable cost will be $1,000.
However, if the company doesn't produce any units, it won't have any variable costs for producing the mugs. Similarly, if the company produces 1,000 units, the cost will rise to $2,000.
One important point to note about variable costs is that they differ between industries, so it's not at all useful to compare the variable costs of a car manufacturer and an appliance manufacturer. That's because their product output isn't comparable.
If you're going to compare the variable costs between two businesses, make sure you choose companies that operate in the same industry.
Companies may also have semi-variable costs. These costs are a mixture of both variable and fixed costs.
Fixed Costs
Fixed costs remain the same regardless of whether goods or services are produced or not. Thus, a company cannot avoid fixed costs. As such, a company's fixed costs don't vary with the volume of production and are indirect, meaning they generally don't apply to the production process—unlike variable costs.
The most common examples of fixed costs include lease and rent payments, property tax, certain salaries, insurance, depreciation, and interest payments.
To demonstrate, let's use the same example from above. In this case, suppose Company ABC has a fixed cost of $10,000 per month to rent the machine it uses to produce mugs. If the company does not produce any mugs for the month, it still needs to pay $10,000 to rent the machine.
But even if it produces one million mugs, its fixed cost remains the same. The variable costs change from zero to $2 million in this example.
Note
A company's net profit is affected by changes in sales volumes. That's because as the number of sales increases, so too does the variable costs it incurs.
Special Considerations
The more fixed costs a company has, the more revenue a company needs to generate to be able to break even, which means it needs to work harder to produce and sell its products. That's because these costs occur regularly and rarely change over time.
While variable costs tend to remain flat, the impact of fixed costs on a company's bottom line can change based on the number of products it produces. So, when production increases, the fixed costs drop. The price of a greater amount of goods can be spread over the same amount of a fixed cost. In this way, a company may achieveeconomies of scale by increasing production and lowering costs.
For example, let's say that Company ABC has a lease of $10,000 a month on its production facility and produces 1,000 mugs per month. As such, it may spread the fixed cost of the lease at $10 per mug. If it produces 10,000 mugs a month, the fixed cost of the lease goes down to the tune of $1 per mug.
Is Marginal Cost the Same as Variable Cost?
The term marginal cost refers to any business expense that is associated with the production of an additional unit of output or by serving an additional customer. A marginal cost is the same as an incremental cost because it increases incrementally in order to produce one more product.
Marginal costs can include variable costs because they are part of the production process and expense. Variable costs change based on the level of production, which means there is also a marginal cost in the total cost of production.
Are Fixed Costs Treated As Sunk Costs?
The term sunk cost refers to money that has already been spent and can't be recovered. While sunk costs may be considered fixed costs, not all fixed costs are considered sunk. For instance, a fixed cost isn't sunk if a piece of machinery that a company purchases can be sold to someone else for the original purchase price.
How Do Semi-Variable Costs Separate Fixed and Variable Costs?
Semi-variable costs are also called semi-fixed or mixed costs. These types of expenses are composed of both fixed and variable components. They are fixed up to a certain production level, after which they become variable. Costs remain fixed even if no production occurs. It's easy to separate the two, as fixed costs occur regularly while variable ones change as a result of production output and the overall volume of activity that takes place.
How Can a Business Reduce Variable Costs?
There are many ways that a business can reduce its variable costs. For instance, increasing output using the same amount of material can dramatically cut down costs, provided the quality of goods isn't impacted.
Developing a new production process can help cut down on variable costs, which may include adopting new or improved technological processes or machinery. If this isn't possible, management may consider analyzing the process to spot opportunities for efficiencies and improvement, which can bring down certain variable costs like utilities and labor.
The Bottom Line
Businesses incur all sorts of costs while conducting operations. Some of these remain static regardless of a business's output, while others will fluctuate. Understanding the differences between these fixed and variable costs will allow businesses to better manage their operations, margins, and overall strategy.
