A guide to fixed vs variable costs Show
Introduction to Fixed and Variable CostsCost 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. 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. Launch our financial analysis courses to learn more! Financial Accounting vs. Managerial AccountingWhile 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:
Variable Costs vs. Fixed CostsThe table below summarizes the key difference between fixed and variable costs:
Example 1 – Fixed vs. Variable CostsThe following table shows various costs incurred by a manufacturing company:
Example 2Let’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.
Launch our financial analysis courses to learn more! Applications of Variable and Fixed CostsClassifying 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. Launch our financial analysis courses to learn more! More Accounting ResourcesThis has been CFI’s guide to Fixed and Variable Costs. To keep learning and advancing your career, the following resources will be helpful:
What are fixed costs also known as?In accounting and economics, 'fixed costs', also known as indirect costs or overhead costs, are business expenses that are not dependent on the level of goods or services produced by the business. They tend to be recurring, such as interest or rents being paid per month.
What is a fixed cost structure?What is Cost Structure? Cost structure refers to the various types of expenses a business incurs and is typically composed of fixed and variable costs. Fixed costs are costs that remain unchanged regardless of the amount of output a company produces, while variable costs change with production volume.
What are four types of fixed costs?Examples of fixed costs are rent and lease costs, salaries, utility bills, insurance, and loan repayments.
Why one cost is called fixed cost?Fixed costs are costs that do not change when sales or production volumes increase or decrease. This is because they are not directly associated with manufacturing a product or delivering a service.
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