Per unit cost remains same, however, total cost varies proportionately. it is -

Fixed and variable expenses are the two main components of a company's total overhead expense. Fixed costs are those that do not fluctuate with changes in production activity level or sales volume, such as rent, insurance, 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 wages and commissions, utilities, inventory, office supplies, and packaging, mailing, and shipping costs.

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. For example, if a bicycle business had total fixed costs of $1,000 and only produced one bike, then the full $1,000 in fixed costs must be applied to that bike. On the other hand, if the same business produced 10 bikes, then the fixed costs per unit decline to $100. Variable costs behave differently. Total variable costs increase proportionately as volume increases, while variable costs per unit remain unchanged. For example, if the bicycle company incurred variable costs of $200 per unit, total variable costs would be $200 if only one bike was produced and $2,000 if 10 bikes were produced. However, variable costs applied per unit would be $200 for both the first and the tenth bike. The company's total costs are a combination of the fixed and variable costs. If the bicycle company produced 10 bikes, its total costs would be $1,000 fixed plus $2,000 variable equals $3,000, or $300 per unit.

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 even), and in making decisions related to pricing goods and services.

Determining the fixed and variable expenses is the first step in performing a break-even analysis. The number of units needed to break even fixed costs / (price variable costs per unit). This equation provides a small business owner with a great deal of valuable information by itself, and it can also be changed around to answer a number of important questions, like whether a planned expansion will be profitable. Knowing how to work with information about fixed and variable expenses can be particularly helpful for individuals who are considering buying a small business. Many businesses, particularly franchises, are reluctant to give out information about projected profits, but will provide information about costs and unit prices. The potential purchaser can then use this information to calculate the number of units and the dollar volume that would be needed to make a profit, and determine whether these numbers seem realistic.

FURTHER READING:

Duncan, Ian. "Controlling Expenses: The Key to Profitability in a Recession." CMA—The Management Accounting Magazine. November 1992.

Hilton, Ronald W. Managerial Accounting. New York: McGraw-Hill, 1991.

Livingstone, John Leslie. The Portable MBA in Finance and Accounting. New York: Wiley, 1992.

"Numbers You Should Know to Keep in Touch with Your Business." Profit-Building Strategies for Business Owners. May 1993.

Fixed cost vs variable cost is the difference in categorizing business costs as either static or fluctuating when there is a change in the activity and sales volume. Fixed cost includes expenses that remain constant for a period of time irrespective of the level of outputs, like rent, salaries, and loan payments, while variable costs are expenses that change directly and proportionally to the changes in business activity level or volume, like direct labor, taxes, and operational expenses.

What this article covers:

NOTE: FreshBooks Support team members are not certified income tax or accounting professionals and cannot provide advice in these areas, outside of supporting questions about FreshBooks. If you need income tax advice please contact an accountant in your area.

What Is Variable and Fixed Cost in Accounting?

Fixed costs are predetermined expenses that remain the same throughout a specific period. These overhead costs do not vary with output or how the business is performing. To determine your fixed costs, consider the expenses you would incur if you temporarily closed your business. You would still continue to pay for rent, insurance and other overhead expenses.

Some examples of fixed costs include:

• Rent
• Telephone and internet costs
• Insurance
• Employee Salaries
• Loan Payments

Any small business owner will have certain fixed costs regardless of whether or not there is any business activity. Since they stay the same throughout the financial year, fixed costs are easier to budget. They are also less controllable than variable costs because they’re not related to operations or volume.

Variable costs, however, change over a specified period and are associated directly to the business activity. These are based on the business performance and the volume of services the business generates.

Some examples of variable costs include:

• Direct labor
• Commissions
• Taxes
• Operational expenses

Since they are changing continuously and the amount you spend on them differs from month-to-month, variable expenses are harder to monitor and control. They can decrease or increase rapidly, cut your profit margins and result in a steep loss or a whirlwind profit for the business.

What Is Fixed Cost and Variable Cost? Examples

1. Fixed Costs Example

Fixed costs remain constant for a specific period. These costs are often time-related, such as the monthly salaries or the rent.

For example, the rent of a building is a fixed cost that a small business owner negotiates with the landlord based the square footage needed for its operations. If the owner rents 10,000 square feet of space at $40 a square foot for ten years, the rent will be $40,000 per month for the next ten years, regardless of the profits or losses.

It is important to note that fixed costs are not constant in the long run. Take the example above. The rent will be the same till the business occupies the space or till the landlord decides to increase the rent after the end of the lease agreement. If the owner decides to move to a bigger facility or pay more, the business expense would obviously go up.

2. Variable Costs Example

Variable costs change directly with the output – when output is zero, the variable cost will be zero. The total variable cost to a business is calculated by multiplying the total quantity of output with the variable cost per unit of output.

A common example of variable costs is operational expenses that may increase or decrease based on the business activity. A growing business may incur more operating costs such as the wages of part-time staff hired for specific projects or a rise in the cost of utilities – such as electricity, gas or water.

Unlike fixed expenses, you can control your variable expenses to leave room for profits.

What Is the Difference Between Fixed Cost and Variable Cost?

Why Is It Important to Distinguish Between Fixed Costs and Variable Costs?

As a small business owner, it is vital to track and understand how the various costs change with the changes in the volume and output levels. The breakdown of these expenses determines the price level of the services and assists in many other aspects of the overall business strategy. These costs are also the primary ingredients to various costing methods employed by businesses including job order costing, activity-based costing and process costing.

1. Break-Even Analysis

The knowledge of the fixed and variable expenses is essential for identifying a profitable price level for its services. This is done by performing the break-even analysis (dollars at which total revenues equal total costs)

Volume needed to break even = fixed costs / (price – variable costs)

The equation provides not only valuable information about pricing but can also be modified to answer other important questions such as the feasibility of a planned expansion. It can also give entrepreneurs, who are considering buying a small business, information about projected profits. The equation can help them calculate the number of units and the dollar volume that would be needed to make a profit and decide whether these numbers seem credible.

2. Economies of Scale

An understanding of the fixed and variable expenses can be used to identify economies of scale. This cost advantage is established in the fact that as output increases, fixed costs are spread over a larger number of output items.

Both fixed costs and variable costs contribute to providing a clear picture of the overall cost structure of the business. Understanding the difference between fixed costs and variable costs is important for making rational decisions about the business expenses which have a direct impact on profitability.

What type of cost remains the same per unit?

Is one that varies in total proportionately with activity?

What is a cost that vary depending as per the number of units?

What costs change proportionately with changes in output levels?