Fixed Cost vs Variable CostDifferences and Comparison
Two of the most common types of costs seen in organizations are fixed and variable costs.
These costs are incurred when a company produces its goods and/or services.
Fixed costs remain fairy unchanged with the amount of output produced, while variable costs fluctuate and change with the amount of output produced.
Fixed costs are costs that do not change as the amounts of goods or services increase or decrease.
A common example of a fixed cost is rent because rent stays constant regardless of the quantity of goods or services produced.
Some other examples of fixed costs include:
- Lease payments
- Rent or mortgage payments
- Property taxes
- Insurance premiums
- Interest expense
Let’s look at an example to better understand fixed costs.
Company ABC is a small manufacturer of sunglasses and has $15,000 in fixed costs each month, which include items like rent and machinery leases.
Let’s say Company ABC closed down for two weeks because of a COVID outbreak.
Even though they did not produce any new sunglasses during this two week period, they sill needs to pay $15,000 for fixed items like rent, machinery leases, etc.
Now let’s use the same example but this time, ABC Company produces twice as many sunglasses in the current month compared to the previous month.
Their variable costs still remain the same: rent, machinery leases, etc.
Regardless of how much or how little ABC Company produces, the fixed costs remain the same.
Variable costs on the other hand, fluctuate depending on the number of goods or services a company produces.
In other words, variable costs increase or decrease in relation to the production volume of the business.
Say it costs ABC Company $1.00 to produce a pair of sunglasses.
If they produce 300 sunglasses, the variable cost is $300 and if they produce 1,000 sunglasses, the variable cost is $1,000.
When ABC Company was closed for two weeks during the COVID outbreak in the example above, they did not produce any sunglasses, therefore they had no variable costs during that period.
Some examples of variable costs include:
- Raw materials that go into products
- Packaging and Shipping
- Piece-rate labor, Hourly wages or Billable labor
- Commission payments
- Certain Utilities
Importance of Knowing your Fixed and Variable Costs
It is important for a business to know their fixed and variable costs because it effects their revenue and profitability.
In other words, the more fixed assets or costs a company has, the more revenue it needs to make in order to break even.
For example, when Company ABC was closed for two weeks, they did not make any revenue to pay their fixed costs.
If they didn’t have a any cash reserves, they may fall behind on their monthly fixed cost obligations.
Company ABC has fixed costs of $15,000 per month.
At $1.00 production cost per pair of sunglasses and a sale price of $9.00 per pair, they need to produce 1,875 mugs to make enough revenue to cover their fixed costs.
Let’s put this into a formula:
Fixed Costs = $15,000/month
Production cost per pair of sunglasses: $1.00
Sale Price per pair of sunglasses: $9.00
Profit per pair of sunglasses: $9.00 – $1.00 = $8.00
Fixed Costs / Profit per pair of sunglasses = Number of sunglasses needed to cover fixed costs
$15,000/$8.00 = 1,875 sunglasses
At the same time, a company may achieve economies of scale by increasing its production and lowering its costs.
The more sunglasses ABC Company produces, the lower the fixed cost amount is because it is spread over a larger amount of production.
You can also use the Fixed Asset Ratio Turnover formula to measure how efficiently property, plant, and equipment is used to turnover revenue.
- Fixed Costs are costs that do not change as the amounts of goods or services increase or decrease.
- Variable Costs fluctuate depending on the number of goods or services a company produces.
- It is important for a business to know their fixed and variable costs because it effects their revenue and profitability.
- A company can achieve economies of scale by increasing its production and lowering its costs.
- The Fixed Asset Ratio Turnover formula is used to measure how efficiently property, plant, and equipment is used to turnover revenue.
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