Fixed Costs

A fixed cost is a cost that remains the same and does not depend on the number of goods and services a company produces. 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 leases stipulate rent hikes of certain percentages, from one year to the next. However, these increases are transparent and baked into the equation, consequently allowing accountants to 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 proceed.

Variable Costs

A variable cost, on the other hand, is a cost that varies, as the amount of goods and services a company produces fluctuates. Simply put: 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. Case in point: A retailer that doubles its typical order to prepare for a holiday rush would shift company ZYX's expenses in accommodating the request to fulfill the order. Larger purchase orders may also result in increased overtime pay companies must shell out to employees who work extra hours to accommodate the spike in sales. Conversely: Purchase orders may decline during off seasons and slower economic climates, which could ultimately downshift labor and manufacturing costs accordingly. In addition, the costs of commodities and other raw manufacturing materials may rise and fall, which can also increase or decrease a company's variable expenses.

Total Costs

Total costs comprise 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, it 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, therefore, be $16,000.

In terms of variable costs, if a company has been mandated to produce 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 therefore be $25,000 ($20,000 in products + $5,000 in labor costs).

Consequently, the total costs, combining $16,000 fixed costs with $25,000 variable costs, would come to $41,000. This number is an essential value a company should be aware of to make sure the business remains fiscally solvent but also thrives over the long term.