When starting a new business, it’s important to understand the difference between fixed and variable costs. Fixed costs are those that stay the same regardless of how much product or service is produced, while variable costs change with production levels. Knowing the difference can help you plan your business more effectively and make sure you’re making a profit.
What is Fixed Cost?
A fixed cost is a cost that does not vary with the level of output produced by a firm. For example, a firm may have to pay a set amount per month for rent, regardless of how much it produces. Fixed costs are important to businesses because they must be covered even when output is zero.
- This means that fixed costs place a lower limit on price; if the price falls below this level, the business will make a loss. A key challenge for businesses is to ensure that their prices are high enough to cover their fixed costs and still be competitive.
- Fixed costs can be contrasted with variable costs, which do vary with output. For example, the cost of raw materials used in production is usually a variable cost. The level of fixed costs faced by a business will depend on the type of business it is and the nature of its products. For example, businesses that require expensive machinery will have higher fixed costs than those that do not.
- It is also worth noting that, although fixed costs do not vary with output in the short run, they may vary in the long run. This is because businesses have some flexibility over the level of fixed costs they face; for example, they may be able to renegotiate their rental agreement or choose a less expensive location. In the long run, all costs are variable because businesses can choose to change their scale of operations.
What is Variable Cost?
Variable costs are those expenses that increase or decrease in relation to the level of production or business activity. Variable costs are contrasted with fixed costs, which are expenses that remain constant regardless of the level of production or business activity. Variable costs can include things like raw materials, commissions, and piece-rate wages.
A key concept in managerial accounting, marginal costing, is based on the idea of variable costing. Under marginal costing, only variable costs are considered when making decisions about pricing and production levels, since these are the costs that will change in response to changes in production levels. While this approach does have its limitations, it can be a useful tool for decision-making in certain situations.
Difference between Fixed and Variable Costs
- The terms fixed costs and variable costs are important in business because they help managers understand where their money is going. Fixed costs are expenses that remain the same regardless of how much or how little is produced, such as rent and insurance. Variable costs fluctuate along with production, such as the cost of raw materials.
- By understanding the difference between these two types of costs, businesses can make more informed decisions about where to allocate their resources. For example, if a company is trying to reduce expenditures, it may look first at its variable costs in order to maximize savings. On the other hand, if a company is trying to increase profits, it may choose to focus on ways to reduce its fixed costs.
- In short, fixed costs are those that do not change with production level, while variable costs are those that do. Understanding this distinction is crucial for effective decision-making in any business.
Conclusion
The difference between fixed and variable costs is an important one to understand for business owners. Fixed costs remain the same, regardless of production levels, while variable costs change with production levels. By understanding which expenses are fixed and which are variable, business owners can make better decisions about pricing, production levels, and more.
