Fixed costs and variable costs are two essential components of the cost structure of any business. It is essential for effective financial planning, budgeting, and decision-making to comprehend the distinction between these two categories of costs.
The behaviour of Fixed and Variable Costs
Fixed costs are expenses that do not vary with production or sales volume. These expenses are incurred whether or not a company produces or sells anything. Rent, salaries, property taxes, insurance premiums, and depreciation are examples of fixed costs. Typically, fixed costs are deemed sunk costs, meaning they cannot be easily adjusted in the short term. Long-term adjustments to fixed costs can be made by altering the business’s size or location, or by renegotiating lease agreements.
Variable costs, on the other hand, are expenditures that vary with production or sales volume. These expenses are proportional to the quantity of products or services produced and sold. Raw materials, direct labour costs, commissions, packaging materials, and shipping costs are examples of variable costs. Variable expenses can be managed by adjusting production levels or the product variety sold. For instance, if a company produces fewer units, its variable costs will be lower.
Impact on the Cost Based on Level of Production
One of the primary distinctions between fixed and variable costs is how they respond to fluctuations in production or sales levels. Fixed costs are unaffected by variations in production or sales volume. For instance, if a business doubles its unit sales, its fixed costs will remain unchanged. If sales decline by half, however, fixed costs will not decrease. This indicates that fixed costs represent a greater proportion of total costs at lesser production or sales levels and a smaller proportion at higher production or sales levels.
Variable costs are directly related to variations in production or sales levels. As production or sales volume increases, variable expenses will also rise. This indicates that variable costs represent a smaller proportion of total costs at lower production or sales levels and a larger proportion at higher production or sales levels.
Impact on Profitability
Another distinction between fixed and variable costs is the effect they have on a company’s profitability. Fixed costs are expenses that remain constant regardless of production or sales volume. This indicates that fixed costs can decrease profitability at modest production or sales levels. However, as production or sales increase, the proportion of fixed costs to total costs decreases, which can contribute to greater profitability. On the other hand, variable costs have a direct impact on profitability. As production or sales increase, variable costs also rise, which can reduce profitability if prices are not adjusted accordingly.