Fixed Cost and Variable Cost is the business cost taken for differentiation. One cost stays constant, and the other fluctuates when a change in activity occurs or sales volume increases or decreases.
Fixed costs, like rent, salaries, and loan payments, remain static regardless of the output level. In contrast, variable costs vary when business activities occur, such as direct labor, taxes, and operational expenses.
In this article we will cover:
- What is Variable and Fixed cost in Accounting?
- Example of Fixed Costs.
- Example of Variable Costs.
- What is the difference between fixed cost and variable cost?
- Why is it important to distinguish between Fixed Cost and Variable Cost?
What is Variable and Fixed cost in Accounting?
Fixed costs remain constant for a specific period, irrespective of production levels, as these costs are predetermined. The cost does not change if any business activity is incurred, so it has to bear these costs. Considering if your business is not in operation for a while, then the expenses incurred are fixed costs. You will have to pay for utilities, insurance, and overhead expenses, etc.
Some examples of fixed costs include:
- Telephone and internet costs
- Employee Salaries
- Loan Payments
Fixed costs are to be paid by the business owners whether there is any business activity going on or not. The fixed costs are easier to make a budget for as they remain the same throughout the year. These costs are less controllable than variable costs.
Variable costs are directly related to business activity, and so they change over a specified time. These costs are associated with the business performance, sales volume that a business generates.
Some examples of variable costs include:
- Direct labor
- Operational expenses
Variable costs change most of the time over the month depending on the business activities. These costs are difficult to monitor as they vary, but they can be controlled so that it is associated with business activity.
Example of Fixed Costs:
Fixed costs remain the same over a specified time. The fixed expenses are time-related most times, such as rent and monthly salaries, wages, etc.
For example, a company rents some machinery to produce cups. The company has to pay a fixed cost of $20,000 monthly as rent for the machinery. If the company is not operating for a month like not producing cups, still it has to pay its rent of $20,000. When the business produces thousands of mugs, it still pays the same amount of rent irrespective of any profit or loss it faces.
The fixed costs are constant for a specified time but can change over time. Like if we take the above example, the rent might change over a year or so; it all depends on the owner; if he wants to increase the rent, then the business expense will also increase and vice versa.
Example of Variable Costs:
Variable costs vary according to the business performance as it is associated directly where if the output level is zero, then the variable cost will also be zero.
Total variable cost is calculated by multiplying the total output with variable cost per unit.
For example, a company produces cups of a cost $3. The company produces 400 units for a month so its variable cost will be $1,200. But if the company stops producing any units then the variable cost will also be null.
The above example shows the relation between variable cost and level of business output.
What is the difference between fixed cost and variable cost?
|Fixed Cost||Variable Cost|
|Meaning: Fixed costs in a business are constant or static expenses that do not relate to business activity or its level of output.||Meaning: Variable costs of a business are directly related to the business performance and its level of output.|
|When incurred: Fixed costs incur regardless of any output produced.||When incurred: Variable costs incur depending on the outputs produced.|
|Nature of cost: The fixed cost is dependent on time and remains constant for some time.||Nature of cost: The variable cost is dependent on volume and increases or decreases with output volume.|
|Also known as: Fixed costs are also known as overhead costs, period costs or supplementary costs.||Also known as: Variable costs are also referred to as prime costs or direct costs as it directly affects the output levels.|
|Impact on Profit: Higher production results in reduced costs which increases profits. Examples: Rent, property taxes, salary, depreciation, etc.||Impact on Profit: There is no impact on profit with the level of production.|
Examples: Sales commission, wages of part-time staff, etc.
Why Is It Important to Distinguish Between Fixed Costs and Variable Costs?
As a small business owner, it is vital to track and understand how the various costs change with the changes in the volume and output levels. The breakdown of these expenses determines the price level of the services and assists in many other aspects of the overall business strategy. These costs are also the primary ingredients to various costing methods employed by businesses including job order costing, activity-based costing, and process costing.
1. Break-even Analysis
The knowledge of the fixed and variable expenses is essential for identifying a profitable price level for its services. This is done by performing the break-even analysis (dollars at which total revenues equal total costs)
Volume needed to break even = fixed costs / (price – variable costs)
The equation provides not only valuable information about pricing but can also be modified to answer other important questions such as the feasibility of a planned expansion. It can also give entrepreneurs, who are considering buying a small business, information about projected profits. The equation can help them calculate the number of units and the dollar volume that would be needed to make a profit and decide whether these numbers seem credible.
2. Economies of Scale
An understanding of the fixed and variable expenses can be used to identify economies of scale. This cost advantage is established in the fact that as output increases, fixed costs are spread over a larger number of output items.
Both fixed costs and variable costs contribute to providing a clear picture of the overall cost structure of the business. Understanding the difference between fixed costs and variable costs is important for making rational decisions about the business expenses which have a direct impact on profitability.
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