Introduction to Fixed Cost and Variable Cost
Students of Commerce to various concepts that are both theoretical yet practical as they are to do with personal and professional finance. If we put our minds to it, we will surely learn a lot! This section deals with the topic of fixed cost and variable cost.
Whether you are part of a company or run a business yourself - cost is a fundamental brick without which no company can ever run! It is the total monetary value incurred by a company for the purpose of manufacturing products or ensuring its services reach the target audience.
Fixed cost remains unmoving for a long period of time while variable cost keeps changing based on the expenditures and assets of the company.
You will know you have understood these two concepts well when you are able to differentiate between fixed and variable cost in a given set of data.
Fixed Cost
The fixed cost is more or less an independent variable. Irrespective of the productivity or operations of a company, these costs have to be borne by the business at all periods of time. For instance, the commercial rent for the structure occupied by the company is an ideal example of fixed cost. It has to be paid by the company throughout its period of functioning, irrespective of whether it is making profits or not.
These costs may rarely be subject to changes. They are usually constant over a long period of time.
Variable Cost
The variable cost as opposed to the fixed cost is dependent on the operations and productivity of the company. A few instances of variable cost include the salaries, utility bills, manufacturing costs and so on. Naturally if the production of the company is at a low, variable costs will be lower. However if the company is running in a full swing, the variable costs will be equally high.
Fixed and variable costs are an essential part of running an organization. But both need to be monitored and kept within their limits. If they exceed a set target, it could prove to be detrimental for the operations of a company.
FAQs on Fixed Costs vs. Variable Costs: Explained with Examples
1. What is a Fixed Cost?
A fixed cost is that kind of expense that does not depend on the level of an organisation’s production. These are time-sensitive expenses and remain fixed for a prolonged period. Expenses under this category include building rent, equipment or machinery that are used in the manufacturing process, etc.
2. What is the Variable Cost?
According to variable cost definition, the cost is dependent on the productivity level of the company. The variable cost formula takes utility bills, cost of purchasing raw materials, etc. under its ambit. One has to incur these expenses based on how much production is effectuated in a company. Accordingly, variable cost changes more frequently.
3. What are the Limitations of Variable Cost?
The variable costs are usually calculated in a linear manner, which is why they often tend to miss out on various essential factors within the organisation. Also, they do not comply with the GAAP (Generally Accepted Accounting Principles), which makes the auditor doubt its credibility too.
4. What are the differences between fixed and variable cost?
Following are the key differences between fixed and variable cost -
As per the definition, fixed cost is borne by the company throughout its functional period while variable cost changes based on the operations and productivity of a firm.
Fixed cost is more or less constant over a period of time while variable cost increases and decreases at regular intervals.
Fixed cost is regular as it needs to be paid to sustain the company while variable cost is incurred as per the productivity of a company.
Constituents of fixed cost include fixed production, fixed selling and fixed administrations. Variable cost includes direct production, direct selling, purchase of raw materials, transportation, labour costs, etc.
5. What is the formula for fixed cost?
To determine a company’s fixed cost, we need to find the difference between the total production incurred and the number of units produced multiplied by the cost of per unit of production.
Hence, Total Fixed Cost = Total production cost - (total number of units produced x per-unit production cost)
6. What is the formula for variable cost?
Variable cost is the product of the total number of units produced or the total output quantity and the per-unit variable cost.
Hence, Variable cost = number of units produced x variable cost of per unit
7. What are the merits and demerits of fixed cost?
As we have seen, fixed costs are constant. They are to be paid irrespective of the operational status of a company. Because they are stable, calculating fixed cost is an easier process. If the production volume of the company increases, they can give rise to profits because they remain the same. Fixed cost reduces tax liability of the organization because it ends up reducing the total income for the year. However, if the company incurs too much fixed cost, it can become an expensive affair. Similarly if the volume of production lowers down, then there is reduction in profits because the fixed costs anyway have to be paid up.
8. What are the pros and cons of variable cost?
Variable costs increase or decrease based on the productivity levels of a company. Once the overall cost is out of the way, the organization can have a better understanding of other costs to sustain production. It helps make informed choices with respect to prices of raw material and manufacturing products. It helps the management understand what levels of production to pull in. Future production costs can also be estimated. However, it might not always be possible to differentiate between fixed and variable costs. In many cases, variable costs might be unable to take into consideration multiple factors that might impact the company. It also does not adhere to the Generally Accepted Accounting Principles, hence it can be questioned by the auditors.
