The difference between fixed and variable costs
/What are Fixed Costs?
A fixed cost is a cost that does not increase or decrease in conjunction with any business activities. Thus, a business will incur fixed costs even when there is no business activity. Examples of fixed costs are rent, insurance, depreciation, salaries, and utilities. A common fixed cost situation for a business is a building that must be heated and air conditioned, even if no one is currently occupying it.
What are Variable Costs?
A variable cost is a cost that varies in relation to either production volume or the amount of services provided. If no production or services are provided, then there should be no variable costs. Examples of variable expenses are direct materials, sales commissions, and credit card fees. A common variable cost situation is a warehouse full of finished goods; these items are not charged to expense until they are sold to a customer.
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Comparing Fixed and Variable Costs
The difference between fixed and variable costs is that fixed costs do not change with activity volumes, while variable costs are closely linked to activity volumes. Thus, fixed costs are incurred over a period of time, while variable costs are incurred as units are sold.
This difference is a key part of understanding the financial characteristics of a business. If the cost structure is comprised mostly of fixed costs (such as an oil refinery), managers need to generate a significant volume of sales in order to pay for the fixed costs being incurred. If they cannot generate sufficient sales, then the business will be forced to close. This means that managers are more likely to accept low-priced offers for their products in order to generate sufficient sales to cover their fixed costs. This can lead to a heightened level of competition within an industry, since they all likely have the same cost structure, and must all cover their fixed costs. Once fixed costs have been paid for, all additional sales typically have quite high margins. This means that a high fixed-cost business can make very large profits when sales spike, but can incur equally large losses when sales decline.
If the cost structure is comprised mostly of variable costs (such as a services business), managers need to turn a profit on every sale, and so are less inclined to accept low-priced offers from customers. These businesses can easily cover their small amounts of fixed costs, and so can stay in business at relatively low sales levels. Variable costs tend to comprise a relatively high proportion of sales, so the profits generated on each individual sale once fixed costs have been covered tend to be lower than under a high fixed cost scenario.
How to Reduce Fixed Costs
It can be difficult to reduce fixed costs. They are usually associated with a longer-term contract (such as a rent agreement), and so can only be adjusted at relatively long intervals. When these arrangements come up for renewal, be sure to put them out for bid, or look for alternative arrangements. For example, it may be possible to shrink the square footage occupied by a business by letting some people work from home, or by outsourcing selected activities. Or, a business could reduce its utility bill by shifting to solar panels mounted on the roof.
How to Reduce Variable Costs
There are several ways to reduce your variable costs. Here are some suggestions:
Obtain volume discounts. A good way to obtain volume discounts is to concentrate your purchases with fewer suppliers, so that the unit volumes purchased from each one increase. This provides you with extra leverage with which to negotiate volume discounts.
Switch to performance-based compensation. Where possible, shift compensation arrangements away from a fixed amount and toward commissions, bonuses, and/or profit sharing. By doing so, your variable wage expenses only increase when the business performs well.
Engage in target costing. Use a strict process of designing new products that have lower costs of materials and/or lower labor costs. If you cannot design a product that meets your target costs, then don’t produce it at all.