Variable Costs vs. Fixed Costs: An Overview

Variable costs and fixed costs, in economics, are the two main types of costs that a company incurs when producing goods and services. Variable costs vary with the amount of output produced, and fixed costs remain the same no matter how much a company produces.

Key Takeaways

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

Variable Costs

Variable costs are a company's costs that are associated with the number of goods or services it produces. A company's variable costs increase and decrease 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 of a car manufacturer and an appliance manufacturer, for example, 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.

You may calculate variable costs by multiplying the quantity of output by the variable cost per unit of output. This calculation is simple and does not take into account any other costs such as labor or raw materials.

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 costs for producing the mugs. Similarly, if the company produces 1000 units, the cost will rise to $2,000.

Examples of variable costs may include labor, commissions, packaging, and raw materials for production.

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

Fixed Costs

Unlike variable costs, a company's fixed costs do not vary with the volume of production. Fixed costs remain the same regardless of whether goods or services are produced or not. Thus, a company cannot avoid fixed costs.

Using the same example above, suppose company ABC has a fixed cost of $10,000 per month to rent the machine it uses to produce mugs. If the company does not produce any mugs for the month, it would still need 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 most common examples of fixed costs include lease and rent payments, utilities, insurance, certain salaries, and interest payments.

Special Considerations

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.

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 costs drop. The price of a greater amount of goods can be spread over the same amount of a fixed cost. In this way, a company may achieveĀ economies of scale by increasing production and lowering costs.

For example, ABC has a lease of $10,000 a month on its production facility and it produces 1,000 mugs per month. As such, it may 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.