What Is the Difference Between the Different Cost Types?
Fixed costs, total fixed costs, and variable costs all sound similar, but there are significant differences between the three. The main difference is that fixed costs do not account for the number of goods or services a company produces while variable costs and total fixed costs depend primarily on that number.
- Fixed costs do not account for the number of goods or services a company produces
- Variable costs and total costs depend on the number of goods or services a company produces.
- Companies must consider both types of costs to ensure they are fiscally solvent and thriving over the long term.
Understanding the Different Cost Types
As the name suggests, fixed costs do not change as a company produces more or less products or provides more or fewer services. For example, rent paid for a building will be the same regardless of the number of widgets produced within that building. In contrast, variable costs do change depending on production volume. For example, the cost of materials that go into producing the widgets will rise as the number of widgets produced increases.
A fixed cost is an expense that a company is obligated to pay, and it is usually time-related. A prime example of a fixed cost would be the rent a company pays for office space and/or manufacturing facilities on a monthly basis. This is typically a contractually agreed-upon term that does not fluctuate unless both landlords and tenants agree to re-negotiate a lease agreement.
In the case of some rental properties, there may be pre-determined incremental annual rent increases where the lease stipulates rent hikes of certain percentages from one year to the next. However, these increases are transparent and baked into the cost equation. Consequently, accountants can calculate their companies' overall budgets with the lead time necessary to ensure a business's bottom line is protected. This is typically how rent-controlled properties operate.
Variable costs are functions of a company's production volume. For example, widget company ZYX may have to spend $10 to manufacture one unit of product. Therefore, if the company receives and inordinately large purchase order during a given month, its monthly expenditures rise accordingly.
Another example is a retailer that doubles its typical order to prepare for a holiday rush. This increases company ZYX's expenses to fulfill the order. Larger purchase orders may also result in increased overtime pay for employees.
Conversely, purchase orders may decline during off-seasons and slower economic times, ultimately pushing down labor and manufacturing costs accordingly. In addition, the costs of commodities and other raw materials for manufacturing may rise and fall, which can also affect a company's variable expenses.
Total costs are composed of both total fixed costs and total variable costs. Total fixed costs are the sum of all consistent, non-variable expenses a company must pay. For example, suppose a company leases office space for $10,000 per month, rents machinery for $5,000 per month, and has a $1,000 monthly utility bill. In this case, the company's total fixed costs would be $16,000.
In terms of variable costs, if a company produces 2,000 widgets at $10 per unit, and it must pay employees $5,000 in overtime to keep up with the demand, the total variable costs would be $25,000 ($20,000 in products plus $5,000 in labor costs).
Consequently, the total costs, combining $16,000 fixed costs with $25,000 variable costs, would come to $41,000. Total costs are an essential value a company must track to ensure the business remains fiscally solvent and thrives over the long term.