Fixed cost vs Variable Cost: Examples
For example, Amy is quite concerned about her bakery as the revenue generated from sales are below the total costs of running the bakery. Amy asks for your opinion on whether she should close down the business or not. Additionally, she’s already committed to paying for one year of rent, electricity, and employee salaries.
You’ll learn the difference between the two and get to grips with their formulas and graphs. We’ll also explore the advantages and disadvantages of a fixed and variable cost pricing model with real-life examples to illustrate the concepts. Overall, variable costs are directly incurred from each unit of production, while fixed costs rise in a step function and are not based on each individual unit. If Amy were to shut down the business, Amy must still pay monthly fixed costs of $1,700. If Amy were to continue operating despite losing money, she would only lose $1,000 per month ($3,000 in revenue – $4,000 in total costs). Therefore, Amy would actually lose more money ($1,700 per month) if she were to discontinue the business altogether.
Variable and fixed costs both represent key expenses of running a business. However, while variable costs change depending on production, fixed costs remain the same even as production and sales volume changes. Fixed costs are the elements of production that don’t change with output; hence the name “fixed”. Because of this, fixed costs are very high at low production levels.
This is deceptive, though, as when output increases, the fixed costs become spread across a more extensive range of production. While this doesn’t make fixed costs lower, it lowers the cost per unit for fixed costs. Understanding different types of costs are essential for businesses to develop a strategy of providing quality products and making a profit. The two kinds of business costs are fixed costs and variable costs. Because variable costs scale alongside, every unit of output will theoretically have the same amount of variable costs. Therefore, total variable costs can be calculated by multiplying the total quantity of output by the unit variable cost.
Variable costs are typically much easier to modify than fixed costs, which makes it very important for business leaders to pay attention to them on a regular basis. Variable cost is one of the two major cost categories that you’ll find in nearly every business endeavor. Together with fixed costs, they form the foundation of all corporate expenses. Even in the top business schools we teach at, there is some confusion over what exactly is defined as a variable cost.
The graph below demonstrates linear variable costs, which is not always the case. Fixed and variable costs help businesses determine cost-based pricing, as the cost of producing a good is the summation of both. Cost-based pricing is the practice of sellers asking for a price that is derived from the cost of producing the item. This is common in competitive markets where sellers seek the lowest price to beat their rivals. The variable cost ratio allows businesses to pinpoint the relationship between variable costs and net sales.
What is another name for variable cost?
Salespeople are paid a commission only if they sell products or services, so this is clearly a variable cost. Production supplies, such as machinery oil, are consumed based on the amount of machinery usage, so these costs vary with production volume. Direct materials is considered the most purely variable cost of all, these are the raw materials that go into a product. Fixed cost examples are rent, property taxes, and salaries.Variable cost examples are hourly wages and raw materials. A business that understands how each cost changes and interacts with its production can more effectively minimize costs to improve its business. Say you’re approached with a business offer from a savvy individual.
- Because commissions rise and fall in line with whatever underlying qualification the salesperson must hit, the expense varies (i.e. is variable) with different activity levels.
- By reducing its variable costs, a business increases its gross profit margin or contribution margin.
- Raw materials are the direct goods purchased that are eventually turned into a final product.
- Fixed cost examples are rent, property taxes, and salaries.Variable cost examples are hourly wages and raw materials.
Average variable costs can be helpful to determine how much the production of 1 unit costs. This can be important in determining the price and value of the product. If you’re selling an item for $200 (Net Sales) but it costs $20 to produce (Variable Costs), you divide $20 by $200 to get 0.1.
Because commissions rise and fall in line with whatever underlying qualification the salesperson must hit, the expense varies (i.e. is variable) with different activity levels. Bert now has to decide whether he wants to maximize profit or maximize time efficiency. This is because he earns more profit per unit, producing 1,000 units than 5,000 units.
Is electricity a variable cost?
Variable cost is a business expense that rises or falls in direct proportion to production volume. The more goods a company produces, the higher variable costs become, and vice versa. While total variable costs change based on production volume, the variable cost per unit produced remains constant. To calculate the total variable costs for a business you have to take into account all the labor and materials needed to produce one unit of a product or service. The total variable cost formula can then be described as the total quantity of output times the variable cost per unit of output.
Understanding which costs are variable and which costs are fixed are important to business decision-making. Another way of analyzing production costs is by tracking the rise and fall of average costs. Average total costs (purple curve) are essential as companies looking to minimize costs want to produce at the lowest point of the average total cost curve. This graph also provides insight into fixed costs (teal curve) and how they interact as the output increases. Fixed costs start very high at low output quantities but quickly dilute and spread out.
For example, if your company sells sets of kitchen knives for $300 but each set requires $200 to create, test, package, and market, your variable cost per unit is $200. As the production output of cakes increases, the bakery’s variable costs also increase. When the bakery does not bake any cake, its variable costs drop to zero. Variable and fixed costs play into the degree of operating leverage a company has. In short, fixed costs are more risky, generate a greater degree of leverage, and leaves the company with greater upside potential. On the other hand, variable costs are safer, generate less leverage, and leave the company with smaller upside potential.
Example of Variable Costs
Knowing the nuances of fixed costs can give producers the option to increase their output quantities to offset significant overhead expenses. Additionally, understanding the U-shaped variable cost will allow businesses to produce at quantities that are the most cost-efficient. By finding the balance between minimizing fixed and variable costs, firms can charge the lowest price possible, beating out the competition. Variable costs are the costs incurred to create or deliver each unit of output.
Fixed costs are costs that don’t change in response to the number of products you’re producing. And, because each unit requires a certain amount of resources, a higher number of units will raise the variable costs needed to produce them. If a company bills out the time of its employees, and those employees are only paid if they work billable hours, then this is a variable cost. However, if they are paid salaries (where they are paid no matter how many hours they work), then this is a fixed cost. The athletic company also won’t incur some types labor if it doesn’t produce more output. Some positions may be salaried; whether output is 100,000 units or 0 units, certain employees will receive the same amount of compensation.
What is the difference between fixed and variable cost?
Variable costs increase or decrease depending on a company’s production or sales volume—they rise as production increases and fall as production decreases. High variable cost businesses primarily focus on increasing their pricing power (think Coach). For each handbag, wallet, etc. that Coach produces, it incurs a variable cost. To maximize each unit of production, Coach has branded its products as a luxury item and charges a premium for each unit of production. High prices, versus high volume at a lower price, is how Coach maximizes profitability.
When Bert makes only a few toothbrushes, he is slow and makes mistakes. However, if he produces a large quantity, he will get into a good rhythm and work more efficiently; this is reflected in decreasing variable costs. If Bert were to try to push himself to produce 5,000 toothbrushes, he would get tired and make a few mistakes. This is reflected in the increasing variable cost at high levels of production. Graphing the different costs can provide insight into how each one plays a role in production. The shape and structure of total, variable, and fixed costs will differ based on industry environments.
If you divide the total variable cost by the total output produced, then you receive the average variable cost (AVC). Profit-maximizing manufacturing companies use the AVC to help them decide at which time they should end the production for a specific good. If the price they receive for the product is higher than the AVC, it is one indicator of a profitable product. A company that seeks to increase its profit by decreasing variable costs may need to cut down on fluctuating costs for raw materials, direct labor, and advertising. However, the cost cut should not affect product or service quality as this would have an adverse effect on sales. By reducing its variable costs, a business increases its gross profit margin or contribution margin.
However, they make a higher overall profit producing at 5,000 units. Bert is thrilled about the business forecast the expert provided him. He also discovers that consumer doggy dental business competitors sell their toothbrushes at $8.
A company must still pay its rent for the space it occupies to run its business operations irrespective of the volume of products manufactured and sold. If a business increased production or decreased production, rent will stay exactly the same. Although fixed costs can change over a period of time, the change will not be related to production, and as such, fixed costs are viewed as long-term costs. Examples of variable costs are sales commissions, direct labor costs, cost of raw materials used in production, and utility costs.
This means that for every sale of an item you’re getting a 90% return with 10% going toward variable costs. Variable costs earn the name because they can increase and decrease as you make more or less of your product. The more units you sell, the more money you’ll make, but some of this money will need to pay for the production of more units. For this reason, variable costs are a required item for companies trying to determine their break-even point. In addition, variable costs are necessary to determine sale targets for a specific profit target.