Fixed vs Variable Cost - Explained
What is a Variable Cost?
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Table of ContentsWhat is a Variable Cost?How Does a Variable Cost Work?Key points:Example of variable cost
What is a Variable Cost?
A variable cost is an expense that varies in accordance with the level of output. Such costs tend to go up or down as per the production activities of a company. Variable costs will increase in case the production increases and decrease in case production falls. For example: costs associated with raw materials, utilities and packaging costs.
What is a Fixed Cost?
A fixed cost remains constant or does not vary with the output of an organization. For example, facility rent may remain the same whether the company produces 1 unit or 1 million units of product.
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How Does a Variable Cost Work?
Every business incurs two types of expenses: fixed and variable. Fixed expenses are the ones that stay consistent irrespective of the levels of production. This means that the company is bound to pay its fixed costs, even if it is not earning any profits, or revenues. For example: salaries, office supplies, insurance, etc. A business firm is ought to pay monthly rent for the property where it carries out its business operations, regardless of the number of units produced and sold. It is possible for fixed costs to vary after a certain time, however the production levels wont be responsible for such change. On the other hand, variable costs completely depend on production levels, The variable cost refers to a certain amount for every unit manufactured. With the production volumes going up, the variable costs will also go up. On the other side, if a company produces lesser quantum of products, the related variable costs will subsequently fall. For example: direct labor costs, commission, utility costs, etc. One can calculate the total variable cost by multiplying the quantum of output produced and the variable cost per unit. Between fixed and variable costs, there exists a category called semi-variable costs. These costs are also known as mixed costs or semi-fixed costs. These costs have elements of both variable and fixed costs. Such costs remain constant for a given production level, and ultimately, start varying once the set level of production is achieved. In case, the company is not carrying out its production process, it will still have to bear fixed costs.
- A variable cost refers to an organizational expense that fluctuates as per the production levels.
- Variable costs depend on the levels of production.
- While a variable cost, being fluctuating in nature, can rise or fall based on several factors, a fixed cost stays constant.
Example of variable cost
For instance, baking expenses per cake incurred by a bakery are $15, which include $5 for buying raw materials including eggs, sugar, flour, etc. and another $10 associated with direct labor used in preparing one cake. By observing the given table, you will see how the number of cakes baked affect the variable costs As more cakes are baked, the production costs increase, and so do the variable costs. In case, the bakery shop doesn't make any cakes, the variable costs become nil. The total cost is the summation of fixed costs and variable costs. It helps in ascertaining the extent of profits made by the company. The formula for arriving at profits is: Profits = Sales - Total costs When a firm controls its total costs, it can see an increase in its profits. As it is difficult for companies to reduce its fixed costs, they should rather focus on decreasing their variable costs. Hence, one can relate decreasing costs with reduced variable costs. In case, the selling price of 1 cake is $35, the firm will make $20 ($35 - $15) as profits. In order to calculate the net profits earned, the firm should subtract fixed costs from the gross profits. Based on the assumption that the fixed costs per month incurred by the bakery were $900, its profit per month will be as follows: When a firms fixed costs are more than its gross profits, the firm suffers a loss. In this example, the bakery earns gross profits of $400 ($700 - $300) on its sale of 20 cakes per month. Because its fixed cost is $900, that is more than its gross profits of $400, it will incur loss of $500 in sale. When fixed costs are equivalent to gross margin, the firm achieves a break-even position (no profit and no loss). So, the bakery selling its 45 cakes for variable cost of $675 will achieve the break-even point. If a company reduces its variable costs with an aim to improve its profits, it may have to control its variable costs involving raw materials, marketing, advertising, direct labor, etc. While cutting down costs, the company must ensure that it is not affecting the quality of product or service. If this happens, there will be less sales, and ultimately, less profits. When a company decreases its variable costs, it experiences a rise in gross profit margin, that is also known as contribution margin. The contribution margin enables a company to ascertain the amount of revenue and profits it will make from every unit sold. The formula for contribution margin is:
Contribution margin = Sales / Gross profit = Sales / (SalesVariable Costs) For the above example, the contribution margin for the bakery firm will be 0.5714 or 57.14%. This value is calculated as follows: ($35 - $15) / $35. If the bakery decides to decrease its variable costs to $10, the new contribution margin will be 71.34% ($35 - $10) / $35. With the increase in contribution margin, the profits of the firm will increase. In case, the bakery plans to lower down its variable costs by $5, it would be able to make $0.71 per dollar for its sales.