Comparison Between Fixed Costs and Variable Costs

Cost is an important concept in economics. It can be understood as the payment made to get services and goods. Cost can be seen from the perspective of consumers and businesses. In this article, you will understand the importance of cost for businesses. Based on variability costs can be of two types- fixed cost and variable cost.

In today’s competitive market, all businesses aim to increase their profits. To be able to do that they need to know its costs and revenues. To become a successful business person this knowledge is important.

In this article, you will learn about what are fixed costs and variable costs. You will also learn about the examples of fixed cost and variable cost and their importance in business decisions.

Defining Fixed Cost

The total cost for a business includes both fixed costs and variable costs. Fixed cost is the expense in the business that does not change with a change in the number of goods and services produced. Due to this nature, fixed cost is also known as an indirect cost. They don’t change over time and are often agreed upon in contracts.

You can understand the fixed cost through this example. Suppose a company XYZ spends INR 50,000 per month to rent a machine to produce plates. Even if the company does not produce any plates they would still have to pay the rent for the machine.

Fixed costs are related to recurring costs which may not always be directly related to the production process. Rent, insurance, interest payment, salaries, and taxes are some fixed-cost examples. Companies decide their shutdown point based on their fixed costs.

Defining Variable Costs

Variable costs change with a change in the production of the company. There is a direct relationship between variable cost and the number of goods produced. As the production volume increases the variable costs also increase.

Variable cost is also known as short-term cost. It can be adjusted quickly. If a company is having cash flow issues it can try to cut down on variable expenses. Raw materials, commissions, utility expenses, and packaging costs are some of the variable cost examples.

Raw materials are the goods that are processed and turned into the final goods. They include coal, wood, oil etcetera. Commissions are the percentage of sales proceeds that are given to a salesperson. Utility expenses include costs like electricity and water bills which differ from endeavor to endeavor. Also, the costs of packaging and shipping goods remain variable.

Fixed Cost Vs. Variable Cost

The following are the differences between fixed cost and variable cost:

	Fixed Cost	Variable Cost
Definition	Fixed costs are costs that do not change when sales or production volumes change. This is because they are not directly involved in developing the product or service.	Variable cost is an expense that changes with a change in sales and output. There is a direct relationship between the number of goods produced and the variable cost.
Duration	Fixed are incurred for a specific period. The period is dependent on the terms of rent contracts etcetera.	Variable cost is also known as short-term cost. The firm can increase or decrease it whenever they want.
Amount	Total fixed cost is the sum of all money minus the variable costs per unit multiplied by the number of units produced.	Total variable cost is the product of the per unit cost and the total number of units sold.
Behavior	For fixed costs, output level has no bearing. On a per-unit basis, it decreases as production increases.	Variable cost increases with increased production. On a per-unit basis, the variable costs remain constant across the production level.
Control	The fixed costs, initially, cannot be controlled. They need to be paid.	A business company controls the variable costs. They can do so by controlling the volume of production.
Nature	Fixed costs increase or decrease only after a specific period.	Variable costs increase as production increases.
Impact on profit	Increased production of goods eventually reduces fixed costs per unit. This increases the profits.	The level of production has no impact on the per-unit cost of goods. Thus, there is no impact on profit levels.
Examples	Rent, salaries, and property taxes	Labour cost, cost of raw materials, and sales commissions

The Importance of Fixed Costs and Variable Costs in Business

Fixed cost and variable cost both have an impact on the gross and operating profits of a business. The higher the costs lower the gross and net profit. Without a healthy profit, an all-encompassing bottom line is also not possible. Companies, therefore, work to reduce costs to increase profits. Since fixed costs cannot always be controlled, it is especially important to manage variable costs.

A tool to weigh the fixed costs and variable costs against profits is a break-even analysis. It determines the cost structure of the company. The number of goods that need to be sold to cover the cost or to break even is calculated by it. The breakeven point is when the company doesn’t make a profit or a loss but recovers all the money it spent.

It is equal to the fixed costs, divided by the average selling price, minus variable costs.

The break-even analysis helps you to manage the size of the units to be sold. It also helps in setting up targets and budgeting. When companies know at what point they will break even, they can easily set up their budgets and goals according to them. This analysis helps the company to have realistic targets.
The break-even analysis also plays an important role in developing safety reports. During financial breakdowns, the sales of companies fall. In such a situation this analysis helps the company calculate the least number of sales needed to make a profit. Thus better business decisions can be made.

Most importantly the break-even point analysis can help design a pricing strategy. By the break-even point calculation, businesses can figure out the minimum prices to cover costs. This point can be measured against the market price to help improve the pricing strategy of the business. It helps determine if the selling prices should be changed.

The break-even analysis is very useful. It is especially important for new and young businesses. The firm’s pricing strategy and practicality are guided by the break-even analysis. This analysis also helps to determine the productivity of the business.

The analysis is also very versatile. It is equally effective even if there is a change in the business model. Stock traders also use this analysis to try to make profits. Investors and financial analysts also use this analysis to make informed investments and decisions.

Strategies for Managing Fixed Costs and Variable Costs

Maintenance of costs is important to ensure the profitability of a business. You can do so by trying to cut down on labour costs. One of the first ways to make budgetary cuts is to cut salaries. You can also reduce your costs by hiring entry-level workers and having 4-day work weeks.

The pandemic has shown that people can work effectively from their homes as well. Working remotely is today preferred by both companies and employees. It is a great way to cut rent costs.

Many businesses take loans initially. These loans often reduce the bottom line of a business. You can try to refinance your mortgages or loans. This can help you reduce your monthly interest payment. Being aware of the market rates is also very important. Many times market rates reduce but your vendor prices stay the same. You can reduce your fixed expenses by getting quotes from multiple vendors or insurance suppliers. By switching to suppliers who offer lower prices you can cut costs.

Many believe that converting fixed costs to variable costs helps reduce the total cost. To do so you can adopt the policy of outsourcing. It is a very effective cost-cutting mechanism. Outsourcing means hiring a third party to perform services that are traditionally done within the company. Instead of hiring full-time salespersons, you can hire independent sales representatives who work on a percentage basis. Unlike employees, they won’t bear the burden of benefits. By reducing your employees you can also cut down on training costs, healthcare expenses, and gratuity.

You can outsource administrative work to a specialized contract maker. Due to the development of technology today many workers have become obsolete. Using new technology and machinery can help you to cut costs. This increased mechanization helps improve efficiency and reduce waste and rework. Using cloud apps can help you to manage stocks and carry out processes that improve productivity.

You must be wondering why you should focus on the optimization of costs. The break-even analysis which is based on these costs helps determine the strength of a business. It helps understand the relationship between fixed costs variable costs and revenue.

Accountants use this analysis to find out the number of sales necessary for a company to make a profit. Thus the lower the fixed cost lower the break-even point. It is also an important tool for budgeting and developing the price policy.

Also read: Net Profit: Understanding Its Significance for Your Business

To Sum Up

Knowledge of both fixed costs and variable costs is important to run your own business. It helps provide you with a clear picture of the business and cost structure. You should know about the influence of these costs on profits and business stability. Understanding the difference between fixed cost and variable cost is important to improve profitability. Also analyzing the break-even point helps new businesses grow.

While needing professional degrees isn’t always important to develop your own business it is always better to know the basics of costing!

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