Fixed and Variable Costs

A guide to fixed vs variable costs

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Written by Tim Vipond

Introduction to Fixed and Variable Costs

Cost is something that can be classified in several ways, depending on its nature. One of the most popular methods is classification according to fixed costs and variable costs. Fixed costs do not change with increases/decreases in units of production volume, while variable costs fluctuate with the volume of units of production. Fixed and variable costs are key terms in managerial accounting, used in various forms of analysis of financial statements.

The first illustration below shows an example of variable costs, where costs increase directly with the number of units produced.

In the second illustration, costs are fixed and do not change with the number of units produced.

Fixed and Variable Costs - Graphical Representation

Graphically, we can see that fixed costs are not related to the volume of automobiles produced by the company. No matter how high or low sales are, fixed costs remain the same.

On the other hand, variable costs show a linear relationship between the volume produced and total variable costs.

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Financial Accounting vs. Managerial Accounting

While financial accounting is used to prepare financial statements that benefit external users, managerial accounting is used to provide useful information to people within an organization, mainly management, to help them make more informed business decisions.

A clear comparison can be seen in the following table:

	Financial Accounting	Managerial Accounting
Purpose of information	To communicate the company’s financial position to external users (i.e. investors, banks, regulators, government)	To help management make better decisions to fulfill the company’s overall strategic goals
Primary users	External users	Internal (management)
Focus and emphasis	Past oriented	Future oriented
Time span	Annual or quarterly financial reports depending on company	Varies from hourly to years of information

Variable Costs vs. Fixed Costs

The table below summarizes the key difference between fixed and variable costs:

	Variable Cost	Fixed Cost
Definition	Costs that vary/change depending on the company’s production volume	Costs that do not change in relation to production volume
When Production Increases	Total variable costs increase	Total fixed cost stays the same
When Production Decreases	Total variable costs decrease	Total fixed cost stays the same
Examples	Direct Materials (i.e. kilograms of wood, tons of cement)	Rent
	Direct Labor (i.e. labor hours)	Advertising
		Insurance
		Depreciation

Example 1 – Fixed vs. Variable Costs

The following table shows various costs incurred by a manufacturing company:

Cost	Variable	Fixed
Depreciation of executive jet		x
Cost of shipping finished goods to customers	x
Wood used in manufacturing furniture	x
Sales manager’s salary		x
Electricity used in manufacturing furniture	x
Packing supplies for shipping products	x
Sand used in manufacturing concrete	x
Supervisor’s salary		x
Advertising costs		x
Executive’s life insurance		x

Example 2

Let’s say that XYZ Company manufactures automobiles and it costs the company $250 to make one steering wheel. In order to run its business, the company incurs $550,000 in rental fees for its factory space.

Let’s take a closer look at the company’s costs depending on its level of production.

Number of Automobiles Produced	Variable Cost per Steering Wheel	Total Variable Cost	Total Fixed Cost
1	$250	$250	$550,000
500	$250	$125,000	$550,000
1000	$250	$250,000	$550,000
1500	$250	$375,000	$550,000

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Applications of Variable and Fixed Costs

Classifying costs as either variable or fixed is important for companies because by doing so, companies can assemble a financial statement called the Statement/Schedule of Cost of Goods Manufactured (COGM). This is a schedule that is used to calculate the cost of producing the company’s products for a set period of time.

The COGM is then transferred to the finished goods inventory account and used in calculating the Cost of Goods Sold (COGS) on the income statement.

By analyzing variable and fixed cost prices, companies can make better decisions on whether to invest in Property, Plant, and Equipment (PPE). For example, if a company incurs high direct labor costs in manufacturing their products, they may look to invest in machinery, which will reduce these high variable costs in exchange for more stable and known fixed costs.

This decision should be made with volume capacity and volatility in mind as trade-offs occur at different levels of production. High volumes with low volatility favor machine investment, while low volumes and high volatility favor the use of variable labor costs.

If sales were low, even though unit labor costs remain high, it would be wiser not to invest in machinery and incur high fixed costs because the high unit labor costs would still be lower than the machinery’s overall fixed cost.

The volume of sales at which the fixed costs or variable costs incurred would be equal to each other is called the indifference point. Finally, variable and fixed costs are also key ingredients to various costing methods employed by companies, including job order costing, process costing, and activity-based costing.

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More Accounting Resources

This has been CFI’s guide to Fixed and Variable Costs. To keep learning and advancing your career, the following resources will be helpful: