The difference between fixed and variable costs is that fixed costs do not change with activity volumes, while variable costs are closely linked to activity volumes. When a cost contains elements of both fixed and variable costs, it is considered a mixed cost.
Fixed Costs are a cost that does not change with an increase or decrease in the amount of goods or services produced. Fixed costs are expenses that have to be paid by a company, independent of any business activity. It is one of the two components of the total cost of a good or service, along with variable cost.
An example of fixed costs would be a company’s lease on a building. If a company has to pay $10,000 each month to cover the cost of the lease but does not manufacture anything during the month, the lease payment is still due in full.
Variable Costs are corporate expense that varies with production output. Variable costs are those costs that vary depending on a company’s production volume; they rise as production increases and fall as production decreases. Variable costs differ from fixed costs such as rent, advertising, insurance and office supplies, which tend to remain the same regardless of production output. Fixed costs and variable costs comprise total cost.
Variable costs can include direct material costs or direct labor costs necessary to complete a certain project. For example, a company may have variable costs associated with the packaging of one of its products. As the company moves more of this product, the costs for packaging will increase. Conversely, when fewer of these products are sold the costs for packaging will consequently decrease.
This difference is a key part of understanding the financial characteristics of a business. If the cost structure is comprised mostly of fixed costs (such as an oil refinery), managers are more likely to accept low-priced offers for their products in order to generate sufficient sales to cover their fixed costs. This can lead to a heightened level of competition within an industry, since they all likely have the same cost structure, and must all cover their fixed costs. Once fixed costs have been paid for, all additional sales typically have quite high margins. This means that a high fixed-cost business can make very large profits when sales spike, but can incur equally large losses when sales decline.
If the cost structure is comprised mostly of variable costs (such as a services business), managers need to turn a profit on every sale, and so are less inclined to accept low-priced offers from customers. These businesses can easily cover their small amounts of fixed costs. Variable costs tend to comprise a relatively high proportion of sales, so the profits generated on each individual sale once fixed costs have been covered tend to be lower than under a high fixed cost scenario.
Examples of fixed costs are rent, insurance, depreciation, salaries, and utilities.
Examples of variable expenses are direct materials, sales commissions, and credit card fees.