Fixed and Variable Costs

Learning Outcomes

  • Differentiate between fixed and variable costs

Costs can also be classified as variable, fixed, or mixed.

Variable Costs

A variable cost remains the same per unit but changes in total. Variable cost examples include sales commissions, hourly workers, and units-of-production method depreciation, as these amounts will change based on total volume, but the amount charged per unit does not change. The most common variable cost would be raw materials. For example, a furniture manufacturer buys parts with which to build tables. Each table consists of a top and four legs. The top costs $500 and each leg costs $50. In addition, it takes two hours for a worker to put the table together, paint it, and wrap it for shipping, and the worker makes $40 per hour including benefits. Therefore, the variable cost for each table is $500 + ($50 * 4) + ($40 *2) = $780. Paint and shipping materials might also be considered variable costs, but since they are very hard to allocate to each table, they will more likely be lumped in with manufacturing overhead and treated as a fixed cost.

Using our example of $780 per unit in material and labor costs, this chart shows how variable costs increase in direct relation to the number of units manufactured.

Graph showing Total Variable Costs. The vertical axis is variable costs. The horizontal axis is units of production. As units of production increase from 0 to 2,000, the variable costs increase in a straight line from $0 to $1,560,000.

Here is a short video recap of variable costs:

You can view the transcript for “Variable Costs” here (opens in new window).

Fixed Costs

Fixed costs remain the same in terms of their total dollar amount, regardless of the number of units sold. These are general expenditures that cannot be traced to any one item sold and may include electricity, insurance, depreciation, salary, and rent expenses.

Fixed costs are considered within a relevant range. The costs remain the same regardless of the number of units sold until capacity has been reached, at which time the company cannot produce or sell any more without spending money for expansion.

For our table manufacturer, assume producing 1,000 tables per month could be done in one facility with one supervisor. However, doubling production would mean renting another assembly facility and hiring another supervisor, doubling fixed costs. Sometimes these costs are referred to as “step” costs because they jump up incrementally as production increases.

However, within a relevant range, say between 0 and 1,000 tables produced, fixed costs do not change. Assume our table company pays monthly rent, insurance, full-time staff, and utilities in the amount of $20,000, and that the company pays assembly workers by the piece, so that if a worker is not needed during the month, he or she does not earn a base salary (just to simplify the example).

If the company produces 0 tables, it still pays the fixed costs of $20,000. At ten tables, the fixed costs are $20,000. At 999 tables, the fixed costs are $20,000. However, at some point (the 1,001st table, in our example) fixed costs increase to accommodate the need for more capacity. The following table shows how fixed costs are fixed, regardless of levels of production, over a relevant range.

Graph showing total fixed costs. The vertical axis is fixed costs. The horizontal axis is units of production. Between 0 and 1,000 units of production, the fixed costs are $20,000. Between 1,100 and 2,000 units of production, the fixed costs are $40,000.

Here is a short video recap of fixed costs:

You can view the transcript for “Fixed Costs” here (opens in new window).

Mixed Costs

As the name implies, mixed costs have both a fixed and a variable component. There is typically a base amount that is incurred even if there are no sales at all. There is also an incremental amount assigned to each unit sold. An example would be equipment rental that costs $8,000 per year plus $1 for each hour used over 10,000 hours.

Now, check your understanding of the difference between fixed and variable costs:

Practice Question