Businesses incur two kinds of operating costs — fixed costs and variable costs. Fixed costs do not vary with output, while variable costs do. i.e., variable costs increase with output but fixed costs broadly stay the same. Fixed costs are sometimes called overhead expenses. They are incurred whether a firm manufactures 100 widgets or 1,000 widgets. In preparing a budget, fixed costs may include rent, depreciation, and supervisors' salaries. Manufacturing overhead may include such items as property taxes and insurance. These fixed costs remain constant in spite of changes in output.
Variable costs, on the other hand, fluctuate in direct proportion to changes in output. In a production facility, labor and material costs are usually variable costs that increase as the volume of production increases. It takes more labor and material to produce more output, so the cost of labor and material varies in direct proportion to the volume of output.
For many companies in the service sector, the traditional division of costs into fixed and variable does not work. Typically, variable costs have been defined primarily as "labor and materials." However, in a service industry labor is usually salaried by contract or by managerial policy and thus does not fluctuate with production. It is, therefore, a fixed and not a variable cost for these companies. There is no hard and firm rule about what category (fixed or variable) is appropriate for particular costs. The cost of office paper in one company, for example, maybe an overhead or fixed cost since the paper is used in the administrative offices for administrative tasks. For another company, that same office paper may well be a variable cost because the business produces printing as a service to other businesses, like Kinkos, for example. Each business must determine based on its own uses whether an expense is a fixed or variable cost to the business.
In addition to variable and fixed costs, some costs are considered mixed. That is, they contain elements of fixed and variable costs. In some cases, the cost of supervision and inspection are considered mixed costs.
Comparison chart
Fixed cost versus Variable cost comparison chart
Fixed cost
Variable cost
Introduction (from Wikipedia)
In economics, fixed costs are business expenses that are not dependent on the level of goods or services produced by the business.
Variable costs are expenses that change in proportion to the activity of a business. Variable cost is the sum of marginal costs over all units produced. It can also be considered normal costs.
introduction to Fixed and Variable Costs
Cost is something that can be classified in several ways depending on its nature. One of the most popular methods is classification according to fixed costs and variable costs. Fixed costs do not change with increases/decreases in units of production volume, while variable costs are solely dependent on the volume of units of production. Fixed and variable costs are key terms in managerial accounting, used in various forms of analysis of financial statements.
The first illustration below shows an example of variable costs, where costs increase directly with the number of units produced.
In the second illustration, costs are fixed and do not change with the number of units produced.
Graphically, we can see that fixed costs are not related to the volume of automobiles produced by the company. No matter how high or low sales are, fixed costs remain the same.
Variable costs, on the other hand, show a linear relationship between the volume produced and total variable costs.
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Financial Accounting vs Managerial Accounting
While financial accounting is required by law and mainly performed to benefit external users, managerial accounting is not required by law and is done to provide useful information to people within an organization, mainly management, to help them make better internal business decisions.
A clear comparison can be seen in the following table:
Financial Accounting
Managerial Accounting
Purpose of information
To communicate the company’s financial position to external users (i.e. investors, banks, regulators, government)
To help management make better decisions to fulfill the company’s overall strategic goals
Primary users
External users
Internal (management)
Focus and emphasis
Past oriented
Future-oriented
Timespan
Annual or quarterly financial reports depending on the company
Varies from hourly to years of information
Variable Costs vs Fixed Costs
The table below summarizes the key difference between fixed and variable costs:
Variable Cost
Fixed Cost
Definition
Costs that vary/change depending on the company’s production volume
Costs that do not change in relation to production volume
When Production Increases
Total variable costs increase
The total fixed cost stays the same
When Production Decreases
Total variable costs decrease
The total fixed cost stays the same
Examples
Direct Materials (i.e. kilograms of wood, tons of cement)
Rent
Direct Labor (i.e. labor hours)
Advertising
Insurance
Depreciation
Example #1 – Fixed vs Variable Costs
The following table shows various costs incurred by a manufacturing company:
Cost
Variable
Fixed
Depreciation of executive jet
x
Cost of shipping finished goods to customers
x
The wood used in manufacturing furniture
x
Sales manager’s salary
x
Electricity used in manufacturing furniture
x
Packing supplies for shipping products
x
Sand used in manufacturing concrete
x
Supervisor’s salary
x
Advertising costs
x
Executive’s life insurance
x
Example #2
Let’s say that XYZ Company manufactures automobiles and it costs the company $250 to make one steering wheel. In order to run its business, the company incurs $550,000 in rental fees for its factory space.
Let’s take a closer look at the company’s costs depending on the company’s level of production.
Number of Automobiles Produced
Variable Cost per Steering Wheel
Total Variable Cost
Total Fixed Cost
1
$250
$250
$550,000
500
$250
$125,000
$550,000
1000
$250
$250,000
$550,000
1500
$250
$375,000
$550,000
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Applications of Variable and Fixed Costs
Classifying costs as either variable or fixed is important for companies because by doing so, companies can assemble a financial statement called the Statement/Schedule of Cost of Goods Manufactured (COGM). This is a schedule that is used to calculate the cost of producing the company’s products for a set period of time.
The COGM is then transferred to the finished goods inventory account and used in calculating the Cost of Goods Sold (COGS) on the income statement.
By analyzing variable and fixed cost prices, companies can make better decisions on whether to invest in Property, Plant, and Equipment (PPE). For example, if a company incurs high direct labor costs in manufacturing their products, they may look to invest in machinery to reduce these high variable costs and incur more fixed costs instead.
These decisions, however, also need to consider how many products are actually being sold. If the company invested in machinery and incurred high fixed costs, it would only be beneficial in a situation where sales are high enough so that the overall fixed costs are less than the total labor costs would have been had the machine not been purchased.
If sales were low, even though unit labor costs remain high, it would be wiser to not invest in machinery and incur high fixed costs because the high unit labor costs would still be lower than the overall fixed cost of the machinery.
The volume of sales at which the fixed costs or variable costs incurred would be equal to each other is called the indifference point. Finally, variable and fixed costs are also key ingredients to various costing methods employed by companies, including job order costing, process costing, and activity-based costing.
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