Fixed and variable costs are the cash outlays that a company has to make to ensure its operation.
The difference between fixed and variable costs is that fixed costs are generated on a regular basis and do not depend on the company’s production or profit levels. While variable costs are only generated depending on the company’s production levels.
For example, a company operating in rented premises will always have to pay rent (fixed cost), but will only have to pay for extra raw materials if production increases (variable cost).
| Fixed costs | Variable costs | |
|---|---|---|
| Definition | These are payments that must be made on a regular basis in order for the business to operate. | These are payments that have to be made on an occasional basis if there is an increase in production. |
| Frequency | Regular (weekly, monthly, bimonthly, bimonthly, etc.) | Irregular (only paid when generated). |
| Types |
|
|
| Dependent on production | Not always. | Yes. |
| They are programmable | Yes. | Sometimes. |
| Examples |
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|
What are fixed costs
These are all the costs that a company will generate on a regular basis, regardless of its production or profit levels. This means that they will be generated regardless of the company’s financial status.
As their name indicates, fixed costs are going to be permanent as long as the company is in operation. For this reason, it is vital to have financial resources that can cover them in case the main sources of income decrease.
An example of a fixed cost is the rent of a business premises. If the rental payment depends directly on the sales of the business, the moment sales decrease, the payment may be compromised, and with it, the operation of the business.
What are the fixed costs
Fixed costs are classified into two categories, depending on their modifiability:
Committed
These are fixed costs that cannot be altered, because doing so may affect the operation of the company. An example would be taxes, since it is required to pay the amount set by the tax entity, otherwise the company may be penalized.
Discretionary
These are fixed costs that can be altered if needed, without impacting the company’s operations. For example, the budget allocated for advertising. If this cost decreases, production is not affected.
Examples of fixed costs
- Rents: of premises, automobiles, furniture, machinery, etc.
- Payroll: of labor and administrative personnel.
- Taxes: local, national taxes, etc.
- Licenses: operating systems, accounting, cloud services, etc.
- Serviceswater, electricity, internet, etc.
- Insurance: against fire, theft, etc.
- Inputs: office supplies, cleaning products, etc.
See also: Difference between cost and expense
What are variable costs
These are costs that originate or vary according to a company’s production levels. Therefore, they are not fixed, since they depend on the company’s operations.
The more production there is, the more variable costs will be generated. And if production decreases, variable costs will also decrease.
Although these types of costs are not foreseen as part of the company’s regular operations (since they are variable), they can be programmed or controlled by the organization.
For example, a company that produces chocolates knows that during the week of Valentine’s Day it sells 120% more boxes of chocolates than a regular sales month, so it prepares in advance to assume the variable costs involved in the increase in production: more raw materials, temporary labor pay or overtime pay, more boxes for the products, etc.
What are the variable costs
Variable costs are classified into three types, depending on the increase or decrease in production:
Progressive
These are all variable costs that increase if production increases. For example, the purchase of more raw materials in an exceptional production season, such as a toy factory preparing for Christmas sales.
Regressive
These are variable costs that decrease as production increases. For example, the more products are produced, the lower the shipping cost.
Proportional
These are costs that are generated according to the quantity produced. For example, a company that produces one thousand extra products will need to buy one thousand more packages.
Examples of variable costs
- Sales commissions: the more products sold, the higher the commissions for employees.
- LaborThe less production, the less labor is needed. And the more production, the more labor.
- PackagingThe more production is generated, the more packaging inputs (bags, boxes, envelopes, etc.) will be required.
- Raw materials: if production increases you have to buy more raw material. And if production decreases you have to buy less quantity.
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