Fixed cost vs Variable cost

What is fixed cost and variable cost?

Understanding different types of costs are essential for businesses to develop a strategy of providing quality products and making a profit. The two kinds of business costs are fixed costs and variable costs.

Fixed costs are expenses that remain the same regardless of the level of production, while variable costs change based on the production output. Rent, advertising, and administrative costs are examples of fixed costs, while examples of variable costs include raw materials, sales commissions, and packaging.

A business that understands how each cost changes and interacts with its production can more effectively minimize costs to improve its business.

Fixed vs. Variable Cost Pricing Model

Total cost tends to decrease at first and then increase later because of how fixed and variable costs react differently to changes in output.

Fixed costs are the elements of production that don't change with output; hence the name "fixed". Because of this, fixed costs are very high at low production levels. This is deceptive, though, as when output increases, the fixed costs become spread across a more extensive range of production. While this doesn't make fixed costs lower, it lowers the cost per unit for fixed costs.

In theory, fixed costs aren't affected by changes in output; however, the fixed production elements have a soft cap on how much output can be handled. Imagine a giant factory that's 5km in area. This factory can easily produce 1 unit or 1,000 units. Despite the building being a fixed cost, there is still a limit to how much production it can hold. Even with a large factory, supporting 100 billion production units would be challenging.

Variable costs can be difficult to understand as they change twice during production. Initially, variable costs start relatively high. This is because producing low quantities doesn't provide efficiency benefits. That changes when output increases enough that variable costs trend downward. Initially, variable costs decreased due to economies of scale.

One element of economies of scale is specialization, also known as the experience curve. This occurs as workers become familiar with and knowledgeable about the production process and become better while providing insights to improve production structure.

Despite economies of scale occurring as output increases, eventually, the opposite will happen. Past a point, diseconomies of scale begin to increase production costs. When production grows too large, it can lead to a loss of efficiency because it becomes hard to manage everything.

Fixed Cost vs. Variable cost: Cost-Based Pricing

Fixed and variable costs help businesses determine cost-based pricing, as the cost of producing a good is the summation of both. Cost-based pricing is the practice of sellers asking for a price that is derived from the cost of producing the item. This is common in competitive markets where sellers seek the lowest price to beat their rivals.

Knowing the nuances of fixed costs can give producers the option to increase their output quantities to offset significant overhead expenses. Additionally, understanding the U-shaped variable cost will allow businesses to produce at quantities that are the most cost-efficient. By finding the balance between minimizing fixed and variable costs, firms can charge the lowest price possible, beating out the competition.

Fixed and Variable Cost Formula

Businesses can use fixed and variable costs to calculate the various concepts to help them maximize their outcomes. Using these formulas can allow companies to determine how changes to their output level can reduce average fixed costs or find the optimal level of variable cost.

A firm's total cost is the sum of its production and non-production costs. Total costs are calculated by summating fixed costs like rent and salaries to variable costs like raw materials and hourly laborers.

\(\hbox{Total Cost}=\hbox{Fixed Costs}+\hbox{(Variable Costs}\times\hbox{Output)}\)

Average total cost is a basic formula for firms looking to maximize profit, as they can produce where the average total cost is the lowest. Or determine if selling at a higher quantity with lower profit margins will yield greater returns.

\(\hbox{Average Total Cost}=\frac{\hbox{Total Costs}}{\hbox{Output}}\)

\(\hbox{Average Total Cost}=\frac{\hbox{Fixed Costs}+\hbox{(Variable Costs}\times\hbox{Output)} }{\hbox{Output}}\)

Average variable costs can be helpful to determine how much the production of 1 unit costs. This can be important in determining the price and value of the product.

\(\hbox{Average Total Cost}=\frac{\hbox{Total Costs}-\hbox{Fixed Costs} }{\hbox{Output}}\)

Average fixed will trend downwards as fixed costs are constant, so as output increases, average fixed costs will decrease dramatically.

\(\hbox{Average Fixed Cost}=\frac{\hbox{Fixed Costs} }{\hbox{Output}}\)

Fixed Cost vs. Variable Cost Graph

Graphing the different costs can provide insight into how each one plays a role in production. The shape and structure of total, variable, and fixed costs will differ based on industry environments. The graph below demonstrates linear variable costs, which is not always the case.

Fig. 1. Total Costs, Variable Costs, and Fixed Costs, StudySmarter Originals

Figure 1 above shows that fixed cost is a horizontal line, meaning the price is the same at all quantity levels. Variable cost, in this case, increases at a fixed rate, meaning that, to produce a higher quantity, the cost per unit will increase. The total cost line is the summation of fixed and variable costs. Simply put, fixed cost + variable cost = total cost. Because of this, it starts at the fixed cost price and then rises at the same slope as variable costs.

Another way of analyzing production costs is by tracking the rise and fall of average costs. Average total costs (purple curve) are essential as companies looking to minimize costs want to produce at the lowest point of the average total cost curve. This graph also provides insight into fixed costs (teal curve) and how they interact as the output increases. Fixed costs start very high at low output quantities but quickly dilute and spread out.

Fig. 2. Average Total, Variable and Fixed Costs, StudySmarter Originals

The average variable cost (dark blue curve) is in a U shape because of economies of scale factors at the mid-level output. However, these effects diminish at higher output levels, as diseconomies of scale raise the cost dramatically at high output levels.

Fixed vs. Variable Costs Examples

Raw materials, labour costs of temporary workers, and packaging are examples of variable costs, while rent, salaries, and property taxes are examples of fixed costs.

The best way to understand fixed and variable costs is to view an example, so see the example below of a business's production costs.

Table 1. Fixed and Variable Costs Example

Table 1 above lists the cost breakdown across five different production quantities.As is consistent with the definition of fixed costs, they remain constant at all production levels. It costs Bert $2,000 annually for rent and utilities to make the toothbrushes in his shed.

When Bert makes only a few toothbrushes, he is slow and makes mistakes. However, if he produces a large quantity, he will get into a good rhythm and work more efficiently; this is reflected in decreasing variable costs. If Bert were to try to push himself to produce 5,000 toothbrushes, he would get tired and make a few mistakes. This is reflected in the increasing variable cost at high levels of production.

Fig. 3. Another Satisfied Customer

Table 2. Total Costs and Revenue Example

Bert now has to decide whether he wants to maximize profit or maximize time efficiency. This is because he earns more profit per unit, producing 1,000 units than 5,000 units. However, they make a higher overall profit producing at 5,000 units. Either option he can choose provides different benefits.