Fixed cost vs Variable cost

Say you're approached with a business offer from a savvy individual. They explain that they need 100 million dollars in overhead costs, but "it's not that big of a deal," they say. "How is 100 million dollars overhead not a big deal?" you exclaim. The individual says, "don't worry that 100 million dollars seem like a lot now, but when we are producing 1 billion products worldwide, it's really only 10 cents per unit sold".

Fixed cost vs Variable cost Fixed cost vs Variable cost

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Table of contents

    Is this person crazy? Does he think that we can make up 100 million dollars with only 10 cents per sale going towards it? Well, the first thing we recommend is you walk away from that conman who wants your money, but secondly, he's surprisingly not wrong. Fixed costs and variable costs operate differently in a business's products, and we'll explain why the offer isn't so bad in this explanation. In this article, we'll take a deep dive into fixed and variable costs and how they can impact your pricing strategy. You'll learn the difference between the two and get to grips with their formulas and graphs. We'll also explore the advantages and disadvantages of a fixed and variable cost pricing model with real-life examples to illustrate the concepts.

    What is fixed cost and variable cost?

    Understanding different types of costs are essential for businesses to develop a strategy of providing quality products and making a profit. The two kinds of business costs are fixed costs and variable costs.

    Fixed costs are expenses that remain the same regardless of the level of production, while variable costs change based on the production output. Rent, advertising, and administrative costs are examples of fixed costs, while examples of variable costs include raw materials, sales commissions, and packaging.

    Fixed costs are business costs that occur regardless of output level.

    Variable Costs are business costs that fluctuate as output changes.

    A business that understands how each cost changes and interacts with its production can more effectively minimize costs to improve its business.

    A small cupcake bakery has a fixed monthly rent of $1,000 for its storefront, as well as a fixed salary expense of $3,000 for its full-time baker. These are fixed costs because they do not change regardless of how many cupcakes the bakery produces.

    However, the bakery's variable costs include the cost of ingredients, such as flour, sugar, and eggs, which are necessary to make cupcakes. If the bakery produces 100 cupcakes in a month, their variable costs for ingredients might be $200. But if they produce 200 cupcakes, their variable cost for ingredients would be $400, as they would need to purchase more ingredients.

    Fixed vs. Variable Cost Pricing Model

    Total cost tends to decrease at first and then increase later because of how fixed and variable costs react differently to changes in output.

    Fixed costs are the elements of production that don't change with output; hence the name "fixed". Because of this, fixed costs are very high at low production levels. This is deceptive, though, as when output increases, the fixed costs become spread across a more extensive range of production. While this doesn't make fixed costs lower, it lowers the cost per unit for fixed costs.

    A business with an overhead of 100 million may seem like a steep fixed cost. However, all expenses are paid for from the profit of selling output. So if the business sold 1 unit of production, it would need to cost 100 million. This contrasts sharply with changes in production. If output increases to 1 billion, the price per unit is only 10 cents.

    In theory, fixed costs aren't affected by changes in output; however, the fixed production elements have a soft cap on how much output can be handled. Imagine a giant factory that's 5km in area. This factory can easily produce 1 unit or 1,000 units. Despite the building being a fixed cost, there is still a limit to how much production it can hold. Even with a large factory, supporting 100 billion production units would be challenging.

    Variable costs can be difficult to understand as they change twice during production. Initially, variable costs start relatively high. This is because producing low quantities doesn't provide efficiency benefits. That changes when output increases enough that variable costs trend downward. Initially, variable costs decreased due to economies of scale.

    One element of economies of scale is specialization, also known as the experience curve. This occurs as workers become familiar with and knowledgeable about the production process and become better while providing insights to improve production structure.

    Despite economies of scale occurring as output increases, eventually, the opposite will happen. Past a point, diseconomies of scale begin to increase production costs. When production grows too large, it can lead to a loss of efficiency because it becomes hard to manage everything.

    Fixed Cost vs. Variable cost: Cost-Based Pricing

    Fixed and variable costs help businesses determine cost-based pricing, as the cost of producing a good is the summation of both. Cost-based pricing is the practice of sellers asking for a price that is derived from the cost of producing the item. This is common in competitive markets where sellers seek the lowest price to beat their rivals.

    Knowing the nuances of fixed costs can give producers the option to increase their output quantities to offset significant overhead expenses. Additionally, understanding the U-shaped variable cost will allow businesses to produce at quantities that are the most cost-efficient. By finding the balance between minimizing fixed and variable costs, firms can charge the lowest price possible, beating out the competition.

    Fixed and Variable Cost Formula

    Businesses can use fixed and variable costs to calculate the various concepts to help them maximize their outcomes. Using these formulas can allow companies to determine how changes to their output level can reduce average fixed costs or find the optimal level of variable cost.

    A firm's total cost is the sum of its production and non-production costs. Total costs are calculated by summating fixed costs like rent and salaries to variable costs like raw materials and hourly laborers.

    Variable costs can be listed as average variable cost per unit or total variable cost.

    \(\hbox{Total Cost}=\hbox{Fixed Costs}+\hbox{(Variable Costs}\times\hbox{Output)}\)

    Average total cost is a basic formula for firms looking to maximize profit, as they can produce where the average total cost is the lowest. Or determine if selling at a higher quantity with lower profit margins will yield greater returns.

    \(\hbox{Average Total Cost}=\frac{\hbox{Total Costs}}{\hbox{Output}}\)

    \(\hbox{Average Total Cost}=\frac{\hbox{Fixed Costs}+\hbox{(Variable Costs}\times\hbox{Output)} }{\hbox{Output}}\)

    Average variable costs can be helpful to determine how much the production of 1 unit costs. This can be important in determining the price and value of the product.

    \(\hbox{Average Total Cost}=\frac{\hbox{Total Costs}-\hbox{Fixed Costs} }{\hbox{Output}}\)

    Average fixed will trend downwards as fixed costs are constant, so as output increases, average fixed costs will decrease dramatically.

    \(\hbox{Average Fixed Cost}=\frac{\hbox{Fixed Costs} }{\hbox{Output}}\)

    Fixed Cost vs. Variable Cost Graph

    Graphing the different costs can provide insight into how each one plays a role in production. The shape and structure of total, variable, and fixed costs will differ based on industry environments. The graph below demonstrates linear variable costs, which is not always the case.

    The graphs shown in this section are samples; each business will have different variables and parameters that change the steepness and shape of the graph.

    Fixed cost vs Variable cost Fig. 1 Total Costs, Variable Costs and Fixed Costs StudySmarterFig. 1. Total Costs, Variable Costs, and Fixed Costs, StudySmarter Originals

    Figure 1 above shows that fixed cost is a horizontal line, meaning the price is the same at all quantity levels. Variable cost, in this case, increases at a fixed rate, meaning that, to produce a higher quantity, the cost per unit will increase. The total cost line is the summation of fixed and variable costs. Simply put, fixed cost + variable cost = total cost. Because of this, it starts at the fixed cost price and then rises at the same slope as variable costs.

    Another way of analyzing production costs is by tracking the rise and fall of average costs. Average total costs (purple curve) are essential as companies looking to minimize costs want to produce at the lowest point of the average total cost curve. This graph also provides insight into fixed costs (teal curve) and how they interact as the output increases. Fixed costs start very high at low output quantities but quickly dilute and spread out.

    Fixed cost vs Variable cost Fig 2. Average Total, Variable and Fixed Costs StudySmarterFig. 2. Average Total, Variable and Fixed Costs, StudySmarter Originals

    The average variable cost (dark blue curve) is in a U shape because of economies of scale factors at the mid-level output. However, these effects diminish at higher output levels, as diseconomies of scale raise the cost dramatically at high output levels.

    Fixed vs. Variable Costs Examples

    Raw materials, labour costs of temporary workers, and packaging are examples of variable costs, while rent, salaries, and property taxes are examples of fixed costs.

    The best way to understand fixed and variable costs is to view an example, so see the example below of a business's production costs.

    Bert is looking to open a business that sells dog toothbrushes, "That's toothbrushes for dogs!" exclaims Bert with a grin. Bert hires a marketing and business expert to create a business plan with financial estimates. The business expert reports his findings below for Bert's potential production options.

    Quantity of outputFixed CostsAverage Fixed CostsTotal Variable CostsVariable CostsTotal CostsAverage Total Costs
    10$2,000$200$80$8$2,080$208
    100$2,000$20$600$6$2,600$46
    500$2,000$4$2,000$4$4,000$8
    1,000$2,000$2$5,000$5$7,000$7
    5,000$2,000$0.40$35,000$7$37,000$7.40

    Table 1. Fixed and Variable Costs Example

    Table 1 above lists the cost breakdown across five different production quantities.As is consistent with the definition of fixed costs, they remain constant at all production levels. It costs Bert $2,000 annually for rent and utilities to make the toothbrushes in his shed.

    When Bert makes only a few toothbrushes, he is slow and makes mistakes. However, if he produces a large quantity, he will get into a good rhythm and work more efficiently; this is reflected in decreasing variable costs. If Bert were to try to push himself to produce 5,000 toothbrushes, he would get tired and make a few mistakes. This is reflected in the increasing variable cost at high levels of production.

    Fixed cost vs Variable cost Another Satisfied Customer StudySmarterFig. 3. Another Satisfied Customer

    Bert is thrilled about the business forecast the expert provided him. He also discovers that consumer doggy dental business competitors sell their toothbrushes at $8. Bert will also sell his product at the market price of $8; with that, Bert tries to decide what quantity to produce.

    Quantity of outputTotal CostsAverage Total CostsTotal ProfitNet IncomeNet Profit Per Unit
    10$2,080$208$80-$2,000-$200
    100$2,600$46$800-$1800-$18
    500$4,000$8$4000$0$0
    1,000$7,000$7$8000$1,000$1
    5,000$37,000$7.40$40,000$3,000$0.60

    Table 2. Total Costs and Revenue Example

    Bert now has to decide whether he wants to maximize profit or maximize time efficiency. This is because he earns more profit per unit, producing 1,000 units than 5,000 units. However, they make a higher overall profit producing at 5,000 units. Either option he can choose provides different benefits.

    Fixed cost vs. Variable cost - Key takeaways

    • Fixed costs are constant production expenses that occur regardless of changes in output, while variable costs are production expenses that change with the level of output.
    • Fixed costs per unit decrease as the level of production increases, as the total cost is spread over a larger number of units, while variable costs per unit tend to stay relatively constant.
    • Economies of scale occur due to efficiencies from producing at higher quantities. These can be experience curves or more efficient production practices.
    • A business's total cost will always increase as output increases. However, the rate at which it increases can change. The average total curve demonstrates how costs increase slower at mid-level outputs.

    References

    1. Figure 3: https://commons.wikimedia.org/wiki/File:BeagleToothbrush2.jpg
    Frequently Asked Questions about Fixed cost vs Variable cost

    What is fixed cost and variable cost example?

    Fixed cost examples are rent, property taxes, and salaries.
    Variable cost examples are hourly wages and raw materials.

    What is the difference between fixed and variable cost?

    Fixed costs are the same whether a firm outputs 1 or 1,000 units. Variable costs increase when a firm goes from producing 1 to 1000 units.

    What are fixed costs vs variable costs?

    Fixed costs are costs that occur regardless of a firm's output, whereas variable costs change with a firm's output.

    Why is it important to know the difference between fixed and variable costs?

    Knowing the difference between fixed cost and variable cost will allow producers to minimize both costs and set up their production to have the most efficient outcomes.

    How do you calculate fixed costs from variable costs and sales?

    Fixed costs=Total Costs - Variable Costs
    Variable costs= (Total Costs- Fixed costs)/Output

    Test your knowledge with multiple choice flashcards

    Fixed costs are always high at high levels of production.

    Fixed costs are high at low levels of production.

    Variable costs are high at high levels of production.

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