Fixed Cost and Variable Costs Example

Fixed Cost

What is Fixed Cost?

Fixed cost is a cost that does not change whether you do or don’t use the service. A common fixed cost is rent for an office space.

Fixed costs are costs that do not vary or change when a business does business. For example, rent is a fixed cost because it does not change whether the business makes a profit or loss. Rent payments still have to be paid whether the business makes a profit or loss.

Fixed costs are also often referred to as “Overheads” and are those costs that cannot be easily traced to any single product or service – they are indirect or semi-manufacturing costs. For example, factory workers’ salaries are considered direct labor, while the cost of the machine they use is indirect.

The building where the product is made is a fixed cost, but the machinery inside it is usually thought of as a manufacturing cost.

The fixed costs are also the costs that arise when production stops. When a factory ceases to produce goods or services, the cost of all manufacturing machinery and equipment is written off by taking charge against inventory at the end of the period. The cost of materials purchased before production has ceased also written off at that time.

Fixed Cost Examples  

Fixed costs are those that do not change depending on the level of business activity. It is a cost that does not vary with the level of production.  It covers all overheads and factory expenses.
Some examples of fixed costs are:

•  Factory rent, salaries, wages, interest on borrowings, insurance premiums, etc.
•  Depreciation of machinery and equipment
• Staff training and recruitment costs
• Outsourced services such as information technology (IT), finance, HR, etc.
• Heating &  lighting
• Security

There is no fixed rule for what is fixed cost or variable cost, and it just depends on the industry you are talking about. The best way to know about the fixed costs example is to determine the difference between fixed cost vs. variable cost.

It is important to note that the fixed cost can differ from industry to industry. The software industry is one of those industries where fixed costs are highest. Major costs like design and development are calculated as fixed costs because they do not change depending on the number of items produced by a company in any given year or month.

For example, if you are running a small business, the costs associated with hiring a sales representative will be very high, and it may be difficult for you to hire one.

However, if you are running a larger business and have bigger revenue streams, you may be able to afford to pay commission to salespeople.

Determine the Fixed Costs

Fixed costs are the most difficult to determine in a business, and there is no formula for it. The best you can do is simply figure them out by looking at your business’s financial reports.

Variable Costs

What is a variable cost?

A variable cost is a cost that changes depending on how many units are produced, such as the price per unit of raw material used to make a unit product. Variable costs are sometimes called indirect material or labor costs.

Variable costs are those that do change depending on the level of business activity. For example, waiters’ food prices and salaries are variable costs because they cost different amounts depending on the amount of business carried out by the restaurant.

Variable Costs Example

Variable Costs are those costs that vary in proportion with production. For example, the cost of raw materials is variable because it varies with production volume.

Some Variable Costs Examples are:

• Raw Materials.
• Wages of Employees who vary with the output level of the company. For example, a fast-food restaurant employs 10 people at peak periods and only 5 people at slower periods. Each staff member has different wages.  In this case, the payroll cost is variable because it varies in proportion to production level.
• The insurance premium changes with the company’s output level and type of coverage (ex: liability insurance).
• Salaries of top executives that vary with company performance.
• Insurance Costs associated with the facility where the operation is carried out. For example, if you have an office that is prone to break-ins regularly, you will pay more insurance premiums than if you only have a small room for inventory and maybe a separate room for offices.
• Maintaining equipment and facilities which varies when the company is achieving different production levels. An example would be the water treatment plant used by a paper mill near mine. The more paper that is produced, the more need for treatment capacity.

Determining Variable Costs

To determine variable costs, one must first identify whether these costs have a unitary or scalable value creation process. For example, raw materials, labor, and other fixed expenses are generally (but not always) unitary because the supplies and human resources required to produce these items can be handled by a single entity.

If a business has a scalable value creation process such as production, the variable costs are not just the raw materials or employees’ labor. The other fixed costs like electricity, rent, and other production-related expenses are also variable costs because they change in proportion to output produced.

For example: if the mine produces less ore, then there will be less need for utilities to run equipment needed to produce ore (less power used). If it produces less ore, then there will probably be less demand for insurance since fewer people are using the mine (fewer accidents).

The cost of raw materials is a potential variable cost. If we consider the example above, raw material costs are likely to vary depending on how much ore can be produced.

For example: if we only produce twenty barrels of ore per day, then our water bill will likely be less than if we produce 250 barrels per day. So, the variable costs are those costs that will change in proportion to the level of production achieved. When we say “in proportion,” that means that if 10% less ore is produced, then 10% less of every variable cost will be incurred.

Difference between fixed and variable costs examples

The main difference between fixed and variable costs is that fixed costs are usually monthly or yearly expenses, whereas variable costs are daily or weekly expenses. Fixed costs can be paid for by using a loan, whereas variable costs must be paid for with cash.

Fixed costs do not have a direct influence on marginal revenue. However, in some cases, fixed costs can reduce marginal revenue when they are paid for by loans (because of the interest paid on the loans). Variable costs are directly related to marginal revenue and will affect profit or loss depending on whether revenue exceeds variable costs.

In short-run and long-run situations, fixed and variable costs influence the break-even point (the point at which total revenues equal total expenses). Fixed costs do not influence the break-even point because they are independent of the level of business activity.

Variable costs directly affect the break-even point because they rise and fall depending on the business activity level.

Comparison of fixed and variable expenses for high-activity and low activity business:

The profit or loss that the business either makes or loses depends on the ratio between revenue and variable costs. If revenue is higher than variable costs, more money remains in the business after fixed costs have been paid for.

This means that the business will have more profit or loss. If revenue is lower than variable costs, there will be less money available to pay for debts and expenses, which means that there will be a loss.

We can see from this example that the profit/loss level of a business is affected by the ratio between revenue and variable costs. The business with higher activity levels will have a greater ratio between revenue and variable costs, which means that it will either make a greater profit or loss than the low-activity example.

A firm that uses independent contractors has fixed costs that remain the same, regardless of how many workers are hired. For example, hiring one worker or one thousand workers will not change the amount that is paid to rent office space. However, hiring workers does change its variable costs.

Is advertising a fixed cost or variable cost?

Advertising is a fixed cost. It is an expense that you need to spend in order to promote your business. However, the amount that you spend on advertising can vary depending on the type of adverts you choose to run and your particular business.

For example, a clothing store could vary the number of adverts it runs depending on the time of year – summer or winter. During the winter months, you will probably need to advertise more, as people are likely to spend less money on clothes. However, during summer you will probably need to advertise less as people are more likely to buy clothes.

As you can see from this example, fixed costs do not necessarily remain constant in terms of value over time. They could even be negative, such as when you decide to close down a business.

Is electricity a fixed or variable cost

A fixed cost is something that doesn’t change, like rent, gasoline prices. But electricity is a variable cost. It can go up and down depending on the time of day, season or weather.

A variable cost is something that changes, like the price of gas if you drive more, gas costs more.

Fixed and variable costs formula

The relationship between fixed and variable costs is vital in any type of business. In fact, it’s the principle that enables businesses to make good profits or control losses.

The Total Cost Formula for a business looks like this: Average Total Cost (ATC) = Fixed Costs + Variable Costs.

In economics, both fixed and variable costs are needed in order to calculate total costs (TC). TC=FC+VC, where FC is fixed costs and VC is variable costs. The total cost curve is a graph that shows how total cost changes as production increases.

The total cost curve is U-shaped; as production increases, so do total costs. When it starts to decrease again, it illustrates how fixed costs change easier than variable costs.

FC= RENT, VC= MATERIALS(PER UNIT OF PRODUCTION)
The average fixed cost of a company can be calculated by dividing the business’s total fixed costs by the number of units produced.

The average variable cost of a company can be calculated by dividing the business’s total variable costs by the number of units produced.

Determining the cost per unit. 

Assuming  that we produce 25,150 units and we have the following;

• Fixed costs = $32,000
• Variable costs = $27,000

Total costs= fixed cost + variable costs= 32,000 + 27,000= $59,000

Cost per unit= 59,000 / 25,150 units = $2.97 per unit

Note: the total cost is the sum of fixed cost plus variable cost. The total cost goes up with the increase in the volume of sales.

Before you can begin, you must first understand the concept of fixed and variable costs. In this sample, we will look at a cost analysis of a vending machine.

There are two types of cost drivers in this business: fixed and variable expenses. Fixed expenses refer to those that do not vary with sales volumes, such as rent, labor, and utility costs.

Variable expenses include everything else – these are the costs that change with each order placed for the item produced by your business. These changes include materials, manufacturing overhead, and shipping costs.