Fixed and variable cost comprise a business' or organization’s total cost. A business or organization can label most costs as either fixed costs or variable costs, including staff salaries, supplies, rent, and any other purchases or bills. Costs that do not change based on the amount of service or the number of goods provided are fixed costs, while variable cost may increase or decrease depending on the amount of service or goods produced. Both types of cost are necessary considerations when performing differential cost analysis.
Costs such as rent and staff salaries are fixed costs because they do not change based on the amount of service or goods produced. For example, the rent must be paid for a leased storefront regardless of how many sales the business has. Similarly, a factory worker who receives a salary or hourly wage does not earn more or less money based on the amount of goods produced by the factory. Rent and salaries are two common fixed costs, but other costs, such as depreciation, also fit into the category.
Variable costs usually include supplies necessary for operation, items purchased for resale, and other items of cost that vary depending on the number of sales, amount of service provided, or the quantity of goods produced. Food in a restaurant, for example, is a variable cost because the amount spent on ingredients relates to how much food the restaurant sells to customers. Items such as take-out containers are variable costs as well.
A cost may sometimes be difficult to categorize, such as electricity. If a factory’s output increases, it may use more electricity. The business can expect to pay minimum amount regardless of the number of goods produced, but the amount could increase based on production like a variable cost. Businesses sometimes use the term mixed costs when difficulties arise in differentiating between fixed and variable cost. Performing some types of financial analysis may require a business to put a mixed cost into either the fixed or variable category.
The distinction between fixed and variable costs is important for business owners. Differential cost analysis requires costs to be categorized and treated differently for individual financial decisions. These categories are used for a number of purposes during differential cost analysis, including profitability analysis and marginal pricing. Break-even point calculations are also a very common use for fixed and variable cost because companies must find the break-even point to determine the amount of service they must provide to prevent losing money.
