The fixed costs of a company are those that are less susceptible to vary according to the volume of production or sales. Variable costs correspond to expenses that increase or decrease proportionally to the level of activity.
In general, fixed costs are spent like renting the property or closed telephone and internet plans. These items have values that remain stable every month, regardless of whether the company produces or sell more or less. Examples of fixed costs are expenses on cleaning, safety and maintenance of machines.
The raw material is a typical example of variable cost. The more products that are manufactured by an industry, the greater will be its consumption of raw material and, therefore, the expenditure on it.
How to differentiate fixed and variable costs?
There is no generic formula, which applies to all cases, to know which costs are fixed and which are variable. This is because the classification of costs varies greatly according to the company’s activity. However, it is easy to understand the meaning of these concepts through examples.
Taking the case of a restaurant that has the same number of employees throughout the year, regardless of the movement, it will have salaries as a fixed cost. However, a construction company that hires workers on contract will have to put the wages of these temporary workers as variable cost, since the more service it has, the greater its need for labor and, therefore, the total cost of that item.
Some costs are considered hybrid, because they have a fixed part and a variable part. In an industry whose production uses a lot of electricity, its cost will increase if it produces more. However, part of the energy consumed by this company – for example, in its administrative sector – will be a constant expense and, therefore, a fixed cost. The same logic applies to water consumption.
In a service company, where the use of water and electricity does not have this particularity, in general these consumption accounts have fixed values and, therefore, can be considered fixed costs.
How to identify the fixed and variable costs of a company?
In order to be able to separate fixed and variable costs in the company’s accounting, the first step is to raise all expenses for a certain period of time. With them, it is possible to assemble a spreadsheet to observe its monthly variation. Ideally, this table should also contain production or sales revenue. Thus, it is possible to understand the relationship between the company’s activity level and the impact on its costs.
Using the history series to separate costs by type, it is easy to calculate fixed and variable costs in monthly reports: just add the values for each of these groups to reach your total.
Importance of knowing fixed and variable costs
In the case of companies that have a seasonal activity, knowing the fixed and variable costs is important for better financial planning throughout the year. But all types of companies can benefit from this knowledge, since the cost structure of a product or service has a direct impact on its price and conditions the possibility for the entrepreneur to make promotions.
If most of a company’s cost is fixed, the more it sells, the greater its profit. This is because, as its cost is always the same, this expense will be proportionally diluted if production increases. The company whose production is more based on fixed costs has, therefore, more advantage when making promotions, since it gains in sales volume.
On the other hand, in the case of a company in which the largest share of the cost is variable, it is necessary to make a profit on each sale. This is because, if the company sells more, the increase in productivity will not have major impacts on the unit cost of the product or service it offers.
A shoe factory has a fixed cost of US $ 10,000. In addition, the company has a variable cost of US $ 5 for each pair of shoes produced. If this industry produces 1,000 pairs of shoes in a month, its cost will be as follows:
Total cost = US $ 10,000 (fixed cost) + US $ 5 x 1,000 (variable cost) = US $ 15,000
Cost per unit = US $ 15 (for a production of 1,000 pairs of shoes)
If that same industry doubles its production, the impact of this increase in cost looks like this:
Total cost = US $ 10,000 (fixed cost) + US $ 5 x 2,000 (variable cost) = US $ 20,000
Cost per unit = US $ 10 (for a production of 2,000 pairs of shoes)
Difference between cost and expense
To better understand the concepts of fixed cost and variable cost, it is also necessary to know how to differentiate costs from expenses. Costs are the expenses that a company has on activities directly related to production. Expenses are indirect. In a factory, what is directly linked to the production line is usually cost, while administrative expenses, for example, are expenses.