The total cost of a business is comprised of fixed costs and variable costs. Fixed costs and variable costs affect the marginal cost of production only if variable costs exist. The marginal cost of production is calculated by dividing the change in the total cost by a one-unit change in the production output level and determines the cost of production for one more unit of good. It is useful in measuring the point at which a business can achieve economies of scale.
A Fixed Cost Doesn't Change
A fixed cost is a cost that remains constant; it does not change with the output level of goods and services. It is an operating expense of a business but is independent of business activity. An example of fixed cost is a rent payment. If a company pays $5,000 in rent per month, it remains the same even if there is no output for the month.
Production Output Level Affects Variable Costs
Conversely, a variable cost is dependent on the production output level of goods and services. Unlike a fixed cost, a variable cost is always fluctuating. This cost rises as the production output level rises and decreases as the production output level decreases. For example, say a company owns a manufacturing plant and produces toys. The electricity bill varies as the production output level of toys varies. If no toys are produced, the company spends less on the electricity bill. If the production output of toys increases, the cost of the electricity increases.
Is It Better for a Company to Have Fixed or Variable Costs?
It is not necessarily better or worse for a company to have either fixed costs or variable costs. In fact, most companies have a combination of fixed costs and variable costs.
A company with a larger number of variable costs when compared to fixed costs shows a more consistent per-unit cost and therefore a more consistent gross margin, operating margin and profit margin. A company with a larger number of fixed costs when compared to variable costs may achieve higher margins as production increases, since revenues increase but costs won't, but it can also result in lower margins if production decreases.
What Type of Cost Change Affects Marginal Cost?
Although the marginal cost measures the change in the total cost with respect to a change in the production output level, a change in fixed costs does not affect the marginal cost. For example, if there are only fixed costs associated with producing goods, the marginal cost of production is zero. If the fixed costs were to double, the marginal cost of production is still zero. The change in the total cost is always equal to zero when there is an absence of variable costs. The marginal cost of production measures the change in total cost with respect to a change in production levels and fixed costs do not change with production levels.
However, the marginal cost of production is affected when there are variable costs associated with production. For example, suppose the fixed costs for a computer manufacturer are $100, and the cost of producing computers is variable. The total cost of production for 20 computers is $1,100. The total cost for producing 21 computers is $1,120. Therefore, the marginal cost of producing computer 21 is $20. The business experiences economies of scale because there is a cost advantage for producing a higher level of output. As opposed to paying $55 per computer for 20 computers, the business can cut costs by paying $53.33 per computer for 21 computers. (For related reading, see: How does marginal cost of production relate to economy of scale?)