The fixed cost is that list of expenses that are not dependent on the productivity of a company. Irrespective of the operations that are taking place in a company, these costs have to be borne by an organisation at all times.
To understand this, let us assume a few fixed cost examples such as rent of a commercial structure, machinery or equipment cost, etc. Herein, the rent of a building/s where a company performs its operations has to be paid irrespective of whether a company is making any profit out of its business or not.
Therefore, the total fixed cost remains the same throughout the period when a company remains operational. Although these costs are subject to change, they rarely differ after having been functional for a prolonged period, depending on other external factors.
A variable cost is opposite to a fixed cost, as it is entirely dependent on the level of a company’s production. Such costs are directly dependent on the productivity level of a company.
For a clear understanding, let us take the help of a few variable cost examples, which are salaries or wages, utility bills, raw materials in production, etc. Thus, all these costs exercise an impact on the amount of a company’s production.
Naturally, when production is low, the total variable cost will be lower. Likewise, when production is in full force, the overall cost of utility bills or raw materials will be more.
Therefore, it is evident that both fixed cost and variable cost are essential to an organisation. However, to operate effectively, it is essential that the costs incurred are as per the limits and do not exceed the prescribed limit for a specific period, failing which the operation of a company may suffer.
The most evident difference between fixed and variable cost is that the former is an independent variable, whereas the latter is a dependent one.
Therefore, it can be seen from fixed and variable costs examples that these items form an integral part of a fully functional organisation. Although they are compared as fixed cost vs variable cost, yet it is due to the presence of these two components that both large organisations and small enterprises can sustain.
The formula for determining a company’s fixed cost is the difference between total production cost and product of the number of units produced and per-unit cost of production.
Total fixed cost = Total cost of production - (number of units produced x cost of per unit of production)
Let us understand the concept with an example.
For instance, there is a company with a unit for manufacturing sanitizers. Based on the current demand of hand-sanitizers, the company was able to produce 50, 000 units of it in April. The total cost of production was found to be Rs. 4,30,000 as determined by their accounts department. Find the fixed cost if the variable cost for each unit was Rs. 5.
Based on the total fixed cost formula, let us first list the data we are provided.
Total number of units manufactured = 50,000
Total cost of production = Rs. 4,30,000
Variable cost of production per unit = Rs. 5
Therefore, fixed cost = 4,30,000 - (5 x 50,000) = Rs. (4,30,000 - 2,50,000) = Rs. 1,80,000
Hence, the fixed cost involved in producing 50,000 units of sanitizers in April was Rs. 1,80,000.
You should note that is the basic fixed cost formula and does not change in any case. However, the calculations prior to this, such as determining fixed costs and others may require a bit of jumble based on the question asked.
Nonetheless, it is different from the average fixed cost formula. It is mentioned below –
Average fixed cost = Total fixed cost/ No. of units produced
What is the Variable Cost Formula?
Quite similar to the calculation of fixed costs, the total variable cost formula requires you to find the product of total output quantity and variable cost of per unit.
Variable cost = number of units produced x variable cost per unit
Let’s look at a simple example to understand these concepts deeply.
For instance, a company called XYZ has to manufacture nearly 70000 units of hand sanitizers of uniform volume in April. Its total cost amounts to Rs. 85,000. Find the total cost associated with such manufacturing and also determine the profit that can be earned. The other details given are:
Labour cost = Rs, 80,000
Raw material cost = Rs. 95,000
Yearly produced units = 1,50,000
Labour cost = 80000/150000 = 0.53
Raw material cost = 95000/150000 = 0.63
Thus, the total variable cost of a single unit = 0.53 + 0.63 = 1.16
Hence, for 70000 units of production, the total variable cost will be =
1.16 x 70000 = Rs. 81,200
Finally, the profit that can be incurred in this case = cost allocated - actual cost = Rs. (85000 - 81200) = Rs. 3, 800.
Students should be able to differentiate between the parameters that are under fixed or variable cost during the calculation. For example, in the above example, labour cost and raw materials cost are dependent on the production volume. Hence, they should be considered under variable cost during the calculation.
The average variable cost formula, on the other hand, requires you to divide the total variable cost by the number of units produced. It can be expressed as –
Average variable cost = Total variable cost/ no. of units produced
Fixed costs are constant expenses for a company, and are less likely to change in due course of time. Irrespective of the business production level, such costs remain constant throughout the operation of a company.
That brings them to benefit the company in multiple ways, such as -
They facilitate more straightforward calculations due to lesser fluctuations.
They give way to more profitability for the organisation with an increase in production volume, although it does not change.
It reduces the net income for a year, thereby reducing the tax liability as well.
However, there are certain limitations to fixed cost as well. In case a company has multiple such costs, it becomes expensive to manage. Also, if there is a fall in production volume, with such costs being constant, there is a reduction in profit margin too.
Variable costs are subjected to change over a period, based on the production level of a company. It is likely to increase or decrease as the production volume rises or plummets, respectively.
As a result, there are certain advantages as well as drawbacks associated with it that are discussed below to provide you with a clear understanding.
Having divided the overall cost facilitates better control over the expenses incurred by a company towards the production and maintenance of an entire organisation.
It also provides the authorities in making informed decisions over the manufactured product’s prices.
They also allow the managerial unit to decide on the level of production that can be favoured by a company at any instance.
Financial planning is enhanced with such costs, as expenses for future sales of production can be estimated.
Alterations in inventory charges do not impact variable costs and thereby, do not affect profit margins as well.
They also act as a judgement tool for a company.
The segregation of fixed and variable costs may not always be accurate in all situations. Variable costs are generally linear and fail to take into consideration multiple factors.
Production costs cannot be calculated solely over variable costs as fixed costs should also be taken into consideration.
Variable costing does not adhere to GAAP, i.e. Generally Accepted Accounting Principles. Therefore, auditors can question its credibility when auditing an organisation.
Nonetheless, students should be careful about calculating the costs while solving numerical. Besides, from a broader perspective, they should also look into the concepts closely from both the company’s as well as managerial viewpoints to get a clearer picture of how these variables work.
For Commerce students, it is essential to build a stronghold on both these concepts. Besides, they should also note that apart from these extreme costs, there are specific costs that are midway and are regarded as semi-variable costs.
Nevertheless, both fixed and variable costs are essential for a company to run effectively. Therefore, when you look to distinguish between fixed cost and variable cost, it is essential to understand both the costs appropriately. To know more about this fixed cost and variable cost examples, you can follow our online learning programmes.
We have a team of experienced tutors to help you guide through the concepts in the most straightforward manner. So, avail our courses now and develop your understanding to fetch high grades in examination.
1. What is a Fixed Cost?
Ans: 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?
Ans: 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?
Ans: 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.