What are ‘Fixed and Variable Costs’?
- Fixed costs tend not to move over a range of sales volume, whereas variable costs will move broadly in line with sales volume.
- These are used in Management Accounting to aid decision-making, for example, when looking at different options for increasing manufacturing capacity or whether to produce or buy new products.
- The calculations are used to review the profitability of different product lines over time.
How are the fixed and variable costs calculated?
Different cost types/headings on the business’ Profit and Loss Account will have dynamics that will enable them to be classified as either Fixed or Variable.
Time can determine here – if a cost does not change over some time, rent, for example, is more likely to be a fixed cost than a variable one.
Similarly, it is usually simple to see that a cost is variable with sales numbers – packaging, delivery costs, manufacturing costs will all often be changeable. The more goods you produce, the more expenses you incur. Therefore, the cost is variable.
Some costs will have a fixed and a variable element. A factory’s heating/power bill, similar to a domestic account, will often have a fixed component that stays the same regardless of how much the factory produces, whereas another part of the bill will vary in a direct relationship to the quantity produced.
There are often step-up costs within the fixed cost category. A factory might at total capacity be sufficient to produce, say, 5,000 cars per month, but if the business wanted to increase production to 20,000 vehicles, a new factory would be required. Hence the factory rental cost would be fixed, but only up to a production level of 5,000 in this instance.
What are the uses of Fixed and Variable Cost calculations?
A business should always be at least aware of the distinction between the two types of cost. When the company is taking on Fixed Costs by their nature, it is more difficult to reduce them immediately. Most Fixed Costs, a lease or premises rental, have a notice period, whereas Variable Costs, flexible labor, for example, don’t have a time or cost implication to terminate.
The theory is that goods or services should at least sell at a price higher than their variable cost. Any amount above that and business cover or contribute towards fixed costs.
The variable/fixed cost dynamic is also used to calculate the Break-Even Point for a product or service.
Fixed Costs/(sales price per unit-variable cost per unit)
Variable and Fixed Costs calculated and referred to in business to take the various decision of pricing and production of goods and services.