Variable Cost vs. Fixed Cost: An Overview

In economics, variable costs and fixed costs are the two main costs a company has when producing goods and services. A variable cost varies with the amount produced, while a fixed cost remains the same no matter how much output a company produces.

Variable Cost

A variable cost is a company's cost that is associated with the amount of goods or services it produces. A company's variable cost increases and decreases with its production volume. When production volume goes up, the variable costs will increase. On the other hand, if the volume goes down, so too will the variable costs.

Variable costs are generally different between industries. Therefore it's not useful to compare the variable costs between a car manufacturer and an appliance manufacturer because their product output isn't comparable. So it's better to compare the variable costs between two businesses that operate in the same industry, such as two car manufacturers.

Variable costs can be calculated by multiplying the quantity of output by the variable cost per unit of output. So, suppose company ABC produces ceramic mugs for a cost of $2 a mug. If the company produces 500 units, its variable cost will be $1,000. However, if the company does not produce any units, it will not have any variable cost for producing the mugs. Similarly, if the company produces 1000 units, the cost will rise to $2,000. This calculation is simple and obviously does not take into account any other costs such as labor or raw materials.

Examples of variable costs include labor costs, utility costs, commissions, and the cost of raw materials that are used in production.

Companies may have what are called semi-variable costs, which are a mixture of both variable and fixed costs.

Fixed Cost

A fixed cost is the other cost incurred by businesses and corporations. Unlike the variable cost, a company's fixed cost does not vary with the volume of production. It remains the same even if no goods or services are produced, and therefore, cannot be avoided.

Using the same example above, suppose company ABC has a fixed cost of $10,000 per month for the rent of the machine it uses to produce mugs. If the company does not produce any mugs for the month, it would still have to pay $10,000 for the cost of renting the machine. On the other hand, if it produces one million mugs, its fixed cost remains the same. The variable costs change from zero to $2 million in this example.

The more fixed costs a company has, the more revenue a company needs in order to break even, which means it needs to work harder to produce and sell its products. That's because these costs occur regularly and rarely change.

The most common examples of fixed costs include lease and rent payments, utilities, insurance, certain salaries, and interest payments.

While variable costs tend to remain flat, the impact of fixed costs on a company's bottom line can change based on the number of products it produces. So, when production increases, the fixed cost drops. The price of a greater amount of goods can be spread over the same amount of a fixed cost. A company can, therefore, achieve economies of scale.

For example, ABC has a lease of $10,000 a month on its production facility and it produces 1,000 mugs per month. It can spread the fixed cost of the lease at $10 per mug. If it produces 10,000 mugs a month, the fixed cost of the lease goes down, to the tune of $1 per mug.

Key Takeaways

  • Companies incur two types of costs: variable costs and fixed costs.
  • Variable costs vary based on the amount of output, while fixed costs are the same regardless of production output.
  • Examples of variable costs include labor and the cost of raw materials, while fixed costs may include lease and rental payments, insurance, and interest payments.