Fixed costs and variable costs are the two major inputs used by a company's management team to determine budgets and control expenses in relation to revenues.
Cost accounting is a business tool used by management to evaluate production costs, prepare budgets, and take appropriate cost control measures to improve the company's profit margins. The purpose of cost accounting is to determine a company's production costs by examining direct and indirect costs involved in manufacturing the company's products.
Fixed costs are one element examined in the process of cost accounting. Fixed costs are independent of changes in production output or revenues. These costs remain relatively the same regardless of whether a company manufactures 10 widgets or 10,000 widgets in a given month. Fixed costs are associated with the basic operating and overhead costs of a business. They include items such as building rent, utilities, wages, and insurance. Most forms of depreciation and tangible assets qualify as fixed costs as well.
Fixed costs are considered indirect costs of production. They are not costs incurred directly by the production process, such as parts needed for assembly, but they nonetheless factor into total production costs. To produce a product or service, the business has to be functioning and operational, and fixed costs represent those necessary operating costs.
"Fixed" in this context does not mean completely unchangeable, only that the costs do not generally change based on production levels or revenue. Fixed costs change somewhat over time as a company makes changes or expands, consequently hiring additional personnel or acquiring new facilities.
Fixed Versus Variable Costs
The other major cost component companies consider in cost accounting is variable costs. Variable costs are the direct production costs that, unlike fixed costs, vary according to levels of production or sales. Variable costs are commonly designated as cost of goods sold (COGS), whereas fixed costs are expenses not usually included in COGS. Fluctuations in sales and production levels can affect variable costs if factors such as sales commissions are included in per-unit production costs.
Fixed costs plus variable costs make up the total ongoing expenses for a company examined in cost accounting for management to analyze expenses in relation to revenues, with the goal of improving cost efficiency and profit margins.
Some companies choose to classify some costs as a combination of fixed and variable costs. An example might be a company's electric bill, part of which is fixed, but part of which varies in accordance with production; more electricity is being used when the production machinery is running.