Fixed Costs, Variable Costs, and the Difference Between Them

Companies incur many expenses during the various stages of production, but are these expenses fixed at all times, regardless of the company’s size and sales volume? Or are they affected by the company’s expansion and increased production? 

This is what we will explore in this article as we explain the difference between Fixed Costs and Variable Costs in companies.  

What are Fixed Costs?

Fixed Costs are defined as the costs that a company commits to without change regardless of the quantity of goods or services it produces or their volume; therefore, the company cannot avoid these costs. 

For example, if a company produces plastic cups and uses rented machinery that costs the company $100,000 per month, then even if the company does not produce a single cup during a given month, it will still be required to pay the machinery rental cost. 

Likewise, if the company produces one million cups in the following month, it will also pay $100,000 with no increase, because it is simply a fixed cost.  

What are Variable Costs?

Variable Costs refer to all costs incurred by the company that are directly related to the volume of goods or services it provides. The value of variable costs increases or decreases depending on the level of production in the company; the higher the production, the higher the variable costs, and vice versa.  

The Difference Between Fixed Costs and Variable Costs

There is a fundamental difference between fixed costs and variable costs, which is reflected in their definition, influencing factors, sensitivity to the number of units produced, and their impact on profits. The differences between fixed and variable costs are explained in detail and clearly in the following table:  
 

  Read also: Everything you want to know about cost accounting  

Examples of fixed costs and variable costs

To enhance your understanding of the difference between fixed and variable costs, we will mention below a set of examples for each type:

First: Fixed Costs

There are many types of fixed costs that companies commit to regardless of their type. Examples include:

• Rent
• Salaries of permanent employees and workers
• Property and real estate taxes
• Insurance
• Website expenses
• Expenses of physical and online stores
• Licensing fees

Second: Variable Costs

There are several aspects directly related to the goods and services produced by the company. Examples of variable costs include:

• Raw material costs
• Packaging costs
• Service expenses
• Transportation costs of goods and merchandise
• Temporary labor costs
• Sales commissions

  Read also: What are direct costs and indirect costs, and the difference between them  

How to Calculate Fixed and Variable Costs

To make informed decisions, you need to learn how to calculate fixed and variable costs, as explained below:  
 

How to Calculate Variable Costs

The financial management should first gather all the costs it incurs and identify which are considered fixed and which are considered variable. 

The company’s financial management must then calculate the variable cost per unit produced, whether it is the cost of raw materials, packaging, shipping, or other related expenses. 

To calculate the total variable cost of all units produced, you can use the following formula: 

Total Variable Cost = Variable Cost per Unit × Total Number of Units Produced 

Example: If a company finds that the variable cost to produce one pair of shoes is $10 (including raw materials, packaging, shipping, etc.), and the company decides to produce 1,000 pairs of shoes, then the total variable cost would be: 

Total Variable Cost = $10 × 1,000 = $10,000  

How to Calculate Fixed Costs

There are two methods through which financial management can determine fixed costs:
 

1. First method: The financial department lists all the expenses required to operate production throughout the year, then divides the total amount by 12 months to determine the monthly fixed cost.
    
2. Second method: This method requires knowing the variable costs of production. The fixed cost can then be calculated using the following formula:
    

Fixed Cost = Total Production Cost − (Variable Cost per Unit × Number of Units Produced) 

Example: If a company needs $10,000 as variable costs to produce 1,000 pairs of shoes, and the total production cost is $15,000, then the fixed cost would be: 

Fixed Cost = $15,000 − $10,000 = $5,000 

How to Calculate Fixed Cost per Unit

To apply the previous formulas, the financial management must calculate the fixed cost per unit by dividing the total fixed cost by the number of units sold. 

Example: If a shoe factory produces 6,000 pairs of shoes, and the total fixed cost is $85,200, then: 

Average Fixed Cost per Unit = $85,200 ÷ 6,000 = $14.20 

Therefore, the financial management must take this cost into account when pricing the shoes. If the factory wants to increase profits, one way is to increase production volume. 

For example, if the factory increases production from 6,000 to 8,000 pairs of shoes, the fixed cost per shoe would drop to approximately $10.65, allowing the company to increase its profit per shoe by $3.55 without increasing fixed costs.  

 Read also: Cost accounting journal entries and how to prepare them  

The Importance of Identifying Fixed and Variable Costs

Analyzing fixed and variable costs plays an important role in various economic operations of organizations. It has a significant impact on profit maximization, product pricing, investment decision-making, and more. 

Among the key benefits of this analysis are helping with product pricing, serving as a fundamental element of planning, and identifying the break-even point. Below are more details on the importance of identifying fixed and variable costs:  
 

Helping with Product Pricing

Every company needs to calculate the costs it incurs to manufacture a product, whether variable or fixed, in order to set a price that covers these costs and achieves an appropriate profit. At the same time, the price must remain reasonable and competitive to attract more customers.  
 

A Fundamental Element of Planning

Fixed and variable costs can affect the planning process carried out by a company’s financial management, especially if the company is planning to expand and increase its production in the following year. In such cases, the company seeks to determine the increase in variable costs associated with higher production and whether it can bear these costs or if doing so would be difficult.  
 

Identifying the Break-Even Point

Analyzing fixed and variable costs helps companies determine their break-even point, which is simply the number of products the company must sell to cover the costs incurred in producing them. This point represents the beginning of profit generation for the company.  

How Does Daftra Help You Track Costs?

To track your fixed or variable costs, you need sufficient data and accurate organization. Through the Daftra software, you can record all your costs, such as employee salaries, rent, shipping material costs, and other expenses.
Daftra provides you with detailed periodic reports to help you understand all the costs and financial aspects of your business or company. 
Subscribe to the Daftra accounting software now and get an integrated system that helps you track costs efficiently.  

Frequently Asked Questions
 

What is the variable cost margin?

It is the portion of revenue that covers variable costs. It indicates the amount of variable cost per unit of sales.  
 

Are electricity and water bills examples of variable costs?

Yes, electricity and water bills are considered variable costs because they change according to the level of consumption.  
 

Are variable costs direct costs?

Yes, variable costs can be direct, but not all variable costs are necessarily direct. Variable costs change with market size, production volume, or other factors, while direct costs are those directly related to the product or service.  
 

How is the variable cost per unit calculated?

The variable cost per unit can be calculated using a simple formula: Total Variable Costs ÷ Number of Units Produced  

What are the methods for separating fixed and variable costs?

1. High–Low Method: This method relies on the highest and lowest levels of production and their associated costs to determine the variable portion of costs. The formula used is: Difference in costs ÷ Difference in number of units. To calculate fixed costs:
    Total Cost − (Variable Cost per Unit × Number of Units).
    
2. Engineering Estimation Method: Uses engineering and technical analysis to estimate the relationship between costs and activity levels.
    
3. Accounting Analysis Method: Each cost item is analyzed to determine whether it is fixed or variable, based on previous accounts and records. This process is carried out by the accountant.
    
4. Linear Regression Method: Uses statistical techniques, such as linear regression, to determine the relationship between costs and activity levels.

Are employee salaries considered variable costs?

Not necessarily. If salaries depend on production or sales, they are considered variable costs. However, if salaries are fixed and do not depend on sales or production, they are considered fixed costs.  

What is the theory of variable costs?

It is a theory that studies costs that change with variations in the volume of production, services, or consumption.  

What are semi-variable costs?

These are costs that are variable up to a certain level. If you are charged based on consumption, the cost is considered variable until it reaches a specific limit, after which it is charged at a fixed rate. In this case, the cost is considered semi-variable.  

Examples of fixed costs in project management include:

• Office or premises rent
• Fixed salaries
• Purchase of fixed equipment
• Internet and telephone services

How are fixed costs allocated within a company?

1. Based on the number of units produced: Total fixed costs ÷ Number of units produced.
2. Based on revenue and production ratios among departments: Costs are allocated proportionally to each department’s contribution.
3. Based on the number of employees or the space used.
4. Using cost centers: Daftra can be used to create cost centers for projects to easily allocate fixed costs.

What is the formula for average fixed cost?

It represents the share of fixed costs per unit produced and is calculated as: Total Fixed Costs ÷ Quantity Produced  

What are semi-fixed costs?

These are costs that are originally fixed. For example, you may pay a fixed price for a certain level of usage. Once that usage exceeds a specific limit, the cost becomes variable and is charged based on consumption. In this case, the cost is fixed up to a certain point and then becomes variable.  

Conclusion

In conclusion, this article has discussed the concept of fixed and variable costs, explained their importance to companies, how to calculate each, and provided simplified practical examples. You can rely on the Daftra accounting software to help you analyze both types of costs easily and automatically, enabling you to achieve maximum profitability.