What are fixed and variable costs and why do they matter to your business? January 13, You may have heard your accountant or your bank manager talk about fixed or variable costs, and wondered what they meant. In this article, written exclusively for Company Bug, Emily Coltman FCA, Chief Accountant to FreeAgent — the popular online accounting system — looks at the different kinds of costs incurred by businesses, and how understanding these costs can help you run your own business more effectively. What is a cost?
Fixed expenses or costs are those that do not fluctuate with changes in production level or sales volume. They include such expenses as rent, Variable and fix cost, dues and subscriptions, equipment leases, payments on loans, depreciation, management salaries, and advertising.
Variable costs are those that respond directly and proportionately to changes in activity level or volume, such as raw materials, hourly production wages, sales commissions, inventory, packaging supplies, and shipping costs. This is important because most business planning activities require that expenses be easily segregated into these two categories.
Those managing businesses soon learn how crucial it is to track expenses in a way that helps to make planning, forecasting and bidding as easy as possible.
Although fixed costs do not vary with changes in production or sales volume, they may change over time.
As a result, fixed costs are sometimes called period costs. Some fixed costs are incurred at the discretion of a company's management, such as advertising and promotional expense, while others are not. It is important to remember that all non-discretionary fixed costs will be incurred even if production or sales volume falls to zero.
Although production and sales volume are the main factors determining the level of variable costs incurred by a company, these costs also may fluctuate in relation to other factors, such as changes in suppliers' prices or seasonal promotional efforts.
Some expenses may have both fixed and variable elements.
For example, a company may pay a sales person a monthly salary a fixed cost plus a percentage commission for every unit sold above a certain level a variable cost. It is important to understand the behavior of the different types of expenses as production or sales volume increases.
Total fixed costs remain unchanged as volume increases, while fixed costs per unit decline. Variable costs behave differently.
Total variable costs increase proportionately as volume increases, while variable costs per unit remain unchanged. The company's total costs are a combination of the fixed and variable costs.
It is very important for small business owners to understand how their various costs respond to changes in the volume of goods or services produced. The breakdown of a company's underlying expenses determines the profitable price level for its products or services, as well as many aspects of its overall business strategy.
A small business owner can use a knowledge of fixed and variable expenses to determine the company's break-even point the number of units or dollars at which total revenues equal total costs, so the company breaks evenand in making decisions related to pricing goods and services.
Economies of scale are another area of business that can only be understood within the framework of fixed and variable expenses. Economies of scale are possible because in most production operations the fixed costs are not related to production volume; variable costs are.
Large production runs therefore "absorb" more of the fixed costs. An example is a printing run. Setting up the run requires burning a plate after a photographic process, mounting the plate on the printing press, adjusting ink flow, and running five or six pages to make sure everything is correctly set up.
The cost of setting up will be the same whether the printer produces one copy or 10, But if 10, pages are printed, each page carries only 0.
The reduction in cost per unit is an economy due to scale.The relation between fixed cost and variable cost can be modelled by an analytical formula. In management accounting, fixed costs are defined as expenses that do not change as a function of the activity of a business, within the relevant period.
Every business manager must identify and track the company's fixed and variable costs. The relationship between the variable costs of manufacturing and the amount of fixed costs determines the sales volume needed to break even and produce a profit.
Top Answer: 1- period cost 2- product cost See More Answers (10) Cost of production are classified into three items; fixed, variable and overheads. these is an assumption without clear definitive line. Fixed costs and variable costs comprise total cost.
Total cost is a determinant of a company’s profits which is calculated as: Profits = Sales – Total Costs. Fixed And Variable Cost When you start a business, you have two types of expenses to consider: fixed costs and variable costs.
Fixed costs are expenses which do not change with sales activity. Variable costs, on the other hand, include all expenses which vary with the . In economics, variable cost and fixed cost are the two main costs a company has when producing goods and services.
A company's total cost is composed of its total fixed costs and its total.