Difference Between Fixed Cost and Variable Cost
Before we look at the difference between Fixed Cost and Variable Cost, let’s take a look at what is a Fixed Cost and a Variable Cost.
Fixed cost is the expense that stays the same, no matter how much a company produces. These costs must be paid, whether the production level is high or low. Unlike variable costs, fixed costs are harder to control because they are not linked to production factors like the number of goods produced. Examples of fixed costs include rent, salaries, and property taxes.
Variable cost changes based on the amount of goods a company produces. When production increases, variable costs go up; when production decreases, they go down. Examples of variable costs include the cost of raw materials, sales commissions, and wages for production workers.
The below table will help students understand the difference between fixed and variable costs in an easy manner.
Fixed Cost and Variable Cost Examples
Fixed costs are expenses that stay the same no matter how much a business produces. Examples include rent, salaries of managers or office staff, property taxes, insurance, and depreciation of equipment.
Variable costs change with the level of production. Examples include the cost of raw materials, wages for workers based on hours or output, sales commissions, packaging costs, and utility bills like electricity that increase with more production.
Fixed Cost and Variable Cost Formula
Fixed Cost Formula:
Fixed Cost = Total Cost - (Variable Cost per Unit × Number of Units Produced)
Variable Cost Formula:
Variable Cost = Variable Cost per Unit × Number of Units Produced
FAQs on Fixed Cost and Variable Cost
1. What is the main difference between fixed costs and variable costs?
The main difference lies in their relationship with production output. Fixed costs, such as rent or salaries, remain constant regardless of how much a company produces. In contrast, variable costs, like raw materials or production wages, fluctuate directly with the volume of goods or services produced.
2. What are some common examples of fixed and variable costs for a business?
Understanding the types of costs is crucial for business management. Here are common examples:
- Fixed Cost Examples: Rent for the factory or office, salaries of administrative staff, insurance premiums, and annual software subscriptions. These must be paid even if production is zero.
- Variable Cost Examples: Cost of raw materials, wages for production workers paid per hour or per unit, sales commissions, and packaging expenses. These costs increase as production rises.
3. How is the total cost of production calculated using fixed and variable costs?
The total cost of production is calculated by adding the total fixed costs and the total variable costs. The formula is: Total Cost (TC) = Total Fixed Cost (TFC) + Total Variable Cost (TVC). This formula helps a business understand its complete expense structure at any given level of output.
4. Can a single cost have both fixed and variable components? Explain with an example.
Yes, these are known as semi-variable or mixed costs. They have a baseline fixed component and a variable component that changes with usage. A common example is a company's electricity bill, which might include a fixed monthly connection charge (fixed cost) plus additional charges based on the amount of electricity consumed during production (variable cost).
5. How do fixed and variable costs influence a company's pricing strategy?
Both costs are critical for setting prices. Fixed costs help determine the break-even point—the minimum sales required to cover all expenses. Prices must be high enough to contribute to covering these fixed costs. Variable costs directly affect the cost of producing each additional unit, influencing the profit margin per item and decisions about scaling production or offering volume discounts.
6. Why does an increase in production volume generally decrease the per-unit fixed cost?
This happens because the total fixed cost is spread over a larger number of units. For example, if the monthly rent (a fixed cost) is ₹50,000, producing 1,000 units makes the per-unit fixed cost ₹50. If production increases to 5,000 units, the per-unit fixed cost drops to just ₹10. This phenomenon is known as 'economies of scale' and is a key driver of profitability at higher production levels.
7. Are fixed costs truly 'fixed' forever? Explain how time affects this classification.
The distinction between fixed and variable costs depends on the time horizon. In the short run, at least one factor of production is fixed (like a factory lease), so costs associated with it are fixed. However, in the long run, a business can change all its inputs. It can rent a larger factory, hire more salaried staff, or buy more machinery. Therefore, in the long run, all costs are considered variable.
8. For a new business, is it better to have a structure with higher fixed costs or higher variable costs?
It depends on the business model and stability of revenue. A structure with higher variable costs and lower fixed costs (e.g., using freelancers instead of salaried staff) offers more flexibility and is less risky if sales are unpredictable. Conversely, a business with higher fixed costs (e.g., a highly automated factory) can achieve a lower per-unit cost at high volumes, leading to greater profitability, but it carries a higher risk during periods of low sales.
