Every enterprise incurs several types of costs while carrying out its business activities. It is necessary to allocate and analyse these costs to assess profitability and to understand how to manage and control them better. To achieve this, there is a need to bifurcate costs into different categories so that they can be rationally allocated across different products or processes. One such bifurcation on the basis of variability is – fixed costs and variable costs.
This article looks at meaning of and differences between two of these cost types more closely.
Definitions and explanations
Fixed costs associated with a product or process are those costs which are incurred irrespective of the level of production. This means that these costs are incurred even if there is no production and continue at the same level even if maximum production is achieved. These are costs that have to be incurred by a business irrespective of its production level.
Fixed costs are associated with but not dependent on production. There is no correlation between the quantum of production and the incurrence of these costs.
These costs are generally fixed for a specific period of time i.e., they are time related and not production related. For example rent is fixed for a year, it may vary in a subsequent year but that could be associated with an escalation cause and not with the level of production.
The incurrence and amount of fixed costs are generally governed by agreements and schedules e.g., lease agreements, interest schedules from the bank.
Fixed costs are generally high in amount but they are still revenue costs and differ from capital costs. For example, cost of machinery is a capital cost and its depreciation is a revenue but fixed cost.
Fixed costs are allocated across products or process based on established cost drivers. These cost drivers are determined by the method of costing used.
Variable costs associated with a product or process are costs which vary with the level of production. If there is no production then these costs will not be incurred.
These costs are directly proportionate to the level of production i.e., if the quantum of production increases, the quantum of this cost also increase.
Examples of these costs are – raw material costs, direct labor costs, other production supplies, transport and freight etc.
Variable costs are generally expressed in a per unit basis and allocated directly to product or process for which they are incurred. These costs remain constant per unit or may decrease per unit in case of economies of scale in production are achieved.
Difference between fixed and variable cost:
The key points of difference between fixed and variable cost have been detailed below:
- Fixed costs are constant costs which are incurred irrespective of the volume of production achieved.
- Variable costs are those costs which change with a change in the volume of production.
2. Related to
- Fixed costs are time related i.e., they vary over a specific period of time.
- Variable costs are production related i.e., they vary with the level of production.
3. At zero production level
- Fixed costs are incurred even if there is zero production.
- Variable costs are directly dependent on production level, hence they are not incurred at zero production level.
4. Per unit amount
- Fixed costs remain at a fixed level and they decrease per unit as quantum of production increases.
- Variable costs remain constant per unit of production; they may decrease per unit of production only in case economies of scale are achieved.
5. Subject to control
- Fixed costs are subject to minimal control as they necessarily have to be incurred to keep the business running irrespective of the level of production.
- Variable costs are only to be incurred for production hence they can be subject to control and limited in lull periods of the business.
- Examples of fixed costs include – rent expenses, interest expenses, property taxes.
- Examples of variable costs include – direct material and direct labor cost.
Fixed vs variable cost – tabular comparison
A tabular comparison of fixed and variable cost is given below:
|Incurred constantly at any level of production
|Change when there is a change in the level of production
|Production level related
|At zero production level
|Incurred at fixed amount
|Per unit amount
|Decreases as quantum of production increases
|Remains constant as quantum of production increases
|Subject to control
|Minimal control is possible
|Significant control is possible
|Rent payments, loan servicing payments and property taxes etc.
|Direct materials and direct labor etc.
Conclusion – fixed vs variable cost:
Fixed costs and variable costs are both considered and allocated by cost accountants while preparing cost sheets of various products and processes. As fixed costs are incurred irrespective of whether there is minimum or maximum production, its impact on profitability is considered secondarily. Businesses seek to budget and control variable costs to reduce incremental cost of production and boost profitability.