Difference Between Fixed Cost and Variable Cost with Example

What’s the main difference between fixed cost and variable cost? Fixed costs are expenses that remain the same regardless of the level of production. Variable costs change based on the production output.

In cost accounting, there are two important types of costs: fixed and variable. These help businesses make informed decisions on budgeting, pricing, and production. 

But, if you find yourself struggling to understand the difference between fixed cost and variable cost, you are not alone. Let’s clear up any confusion now. 

Fixed Costs versus Variable Costs: Key Differences

Aspect	Fixed Costs	Variable Costs
What they are	Costs that stay the same, no matter how much we make or sell	Costs that change when we make or sell more or less
Examples	Rent, insurance, salaries of regular workers	Materials, labour, commissions
How they act	Stay steady even if things change	Go up or down as things change
Break-Even	Help decide when we start making a profit	Help figure out how much we need to sell to cover costs
Planning	Good for making budgets and plans	Need to think about them when we decide how much to make
Pricing	Decide how low we can go	Help decide how much extra we can charge
Decisions	Help us plan for the long term	Help us decide how much to make right now

What are Fixed Costs?

A fixed cost refers to the expenses of a business that remain constant no matter how much it produces or sells. These commitments do not change. A business must spend a pre-defined amount to keep its operations running smoothly.

Examples of Fixed Costs

A manufacturing company leasing a factory. The fixed costs include the following. 

• The monthly rent for the factory space remains unchanged. Whether the company produces 100 units of its product or none, the rent will not change. 
• Insurance premiums and the salaries of salaried employees will not change even if the production line operates at varying capacities.

These fixed costs provide a baseline level of expenses that estimate future costs. This can be helpful for budgeting and planning.

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What are Variable Costs?

Variable costs are part of the level of production or sales. As production scales up or down, these costs fluctuate accordingly. Variable costs directly depend on the raw materials used in the production process. 

Variable costs directly affect the production volume. They increase or decrease with rising or falling production or sales.

Some of these can include the following. 

• Cost of raw materials 
• Labour wages of temporary workers hired during peak production times
• Sales commissions paid to employees.

Examples of Variable Costs

A bakery that produces bread. Here, the variable costs include the ones below.

• The flour and yeast used in making each loaf of bread constitute variable costs. As the bakery increases its production, the consumption of these ingredients rises proportionally. That increases variable costs. 
• If the bakery cuts down on production, the corresponding reduction in raw material usage results in lower variable costs.

Uses of Fixed Costs vs Variable Costs

A thorough comprehension of the distinction between fixed and variable costs is essential for making informed decisions in various business scenarios.

Fixed costs remain constant. They do not change and describe the business’s financial scenario. In contrast, variable costs keep changing depending on the changes in production.

How Businesses Use Fixed Costs for Long-Term Planning

Fixed costs play a pivotal role in long-term strategic planning. Since they remain steady, businesses can forecast and project their financial commitments with high certainty. This stability provides a solid foundation for growth strategies. It allows companies to allocate resources effectively.

Impact of Variable Costs on Production Decisions

Variable costs directly influence the decision-making process related to production. As companies adjust their production levels, the fluctuation in variable costs influences the overall cost structure. This impact demands meticulous consideration to balance production volume and associated costs.

Break-Even Analysis with Fixed and Variable Costs

Break-even analysis calculates the level of production at which a business no longer makes a profit or loss. One can calculate it by dividing fixed costs by the contribution margin per unit. The contribution margin is the difference between the selling price per unit and the variable cost per unit.

Budgeting and Forecasting Considerations

Budgeting and forecasting become more than routine tasks when considering fixed and variable costs. Fixed costs provide a predictable foundation for budgeting. It helps companies understand how and when to allocate funds for essentials confidently. 

Variable costs are less predictable. But that allows for more informed forecasts by considering production fluctuations.

Decision-Making in Cost Control and Optimisation

Efficient cost control relies heavily on the distinction between fixed and variable costs. Companies can devise strategies to reduce unnecessary expenses and optimize resource allocation by identifying fixed costs. 

Furthermore, understanding variable costs aids in making informed decisions about production levels. That’s how the associated costs are both manageable and justifiable.

Example of Relationship Between Fixed and Variable Costs 

Let’s delve into a scenario to grasp the practical implications of the difference between fixed and variable costs.

Scenario: Manufacturing Company, ArcaneMachina Industries

ArcaneMachina Industries is a manufacturing company. It produces high-tech gadgets. Its fixed costs encompass the rent of its state-of-the-art facility, insurance premiums, and salaries of core staff. These costs remain consistent, irrespective of production fluctuations.

In terms of variable costs, production volume directly affects the cost of electronic components and assembly labour.

As ArchaneMachina increases gadget production to meet high demand, its variable costs surge. Conversely, during slow periods, the reduction in production volume leads to a decrease in variable costs.

Analysis of Impact on Business Operations and Financial Performance**

ArchaneMachina’s understanding of fixed and variable costs empowers its decision-making. The stable nature of fixed costs gives the company financial predictability. That enables confident plan expansion strategies. 

The company’s control over variable costs allows it to navigate production fluctuations judiciously. This prevents overcommitment during quiet times and capitalising on peak demand.

Parting Thoughts

The difference between fixed cost and variable cost isn’t just learning as an accounting concept. This distinction makes for a strategic tool for businesses to navigate the complex terrain of financial decisions. 

By understanding these cost types, businesses can set prices, plan ahead, and improve operations efficiently. 

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