Variable vs Fixed Costs
The aim of any private firm is to make a profit. In order to maximize profitability, the firm must aim to raise revenues and minimize costs. In order to reduce these costs, a firm must be able to identify and measure costs included in the factors of production such as wages, rent, electricity, materials and supplies and so on. These costs can be divided into two types; variable cost and fixed cost. The article will carry the reader through the differences between fixed and variable costs incurred by firms with examples on each.
Variable costs are the costs that vary directly in accordance to changes in the levels of output. Variable costs include costs such as direct material costs, hourly rate wages and utility costs directly related to production levels. Taking an example, if a firm producing 10,000 cars per month incurs a variable cost of $2000 per car, the total variable cost of producing 10,000 cars would be $20 million. In setting prices, it is essential that the price set is higher than the variable cost of production. So that, cumulative amount left after covering variable costs will be able to cover the total fixed costs incurred. The advantage of variable costs is that the cost will not be incurred when production slows down, and this will not pose a strain during times of lower production levels.
Fixed costs are costs that remain constant regardless of the levels of production. Examples of fixed costs are rental costs, insurance expenses and cost of fixed assets. It is pertinent to note that fixed costs are only fixed in correspondence to the quantity produced in the current period, and will not remain fixed for an indefinite period, since costs increase over time. The production of 10,000 cars will incur a fixed cost of $10 million each month, regardless of whether the full capacity is produced or not. In a scenario, where the firm wants to increase its production to 20,000 units, more equipment and a bigger factory will have to be bought. The disadvantage of fixed costs is that during times of lower production levels the firm will still have to incur the high fixed costs.
What is the difference between Variable and Fixed Costs?
The total of fixed costs and variable costs make up the total cost, which can be used to calculate the breakeven point, the point at which total revenue is equal to the total cost and the point that must be exceeded in order to make a profit. Variable costs can be easily managed as opposed to fixed costs as variable costs are in direct relation to production levels, whereas fixed costs are not. However, both variable costs and fixed costs need to be constantly evaluated and managed in order to ensure that they in some correspondence to production levels ensuring that a profit can be made.
In a Nutshell, Variable Cost vs Fixed Cost
• Variable costs are in direct correlation to the levels of production, as opposed to fixed costs that are incurred regardless of the levels of production.
• Variable costs can be easily managed and reduces the financial strain on the firm during times of low production levels, compared to fixed costs that can be distressing for a firm that needs to maintain equipment, factories and facilities even when optimum production levels are not reached.
• A firm must strive to set higher prices that are able to cover both fixed and variable costs, and must be able to reach a point above break even to make a profit.