Fixed and Variable Costs

A guide to fixed vs variable costs

Introduction to fixed and variable costs

Fixed costs do not change with increases/decreases units of production volume, while variable costs are solely dependent on the volume of units of production. Fixed and variable costs are key terms relevant in managerial accounting that are 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.

 

fixed and variable costs

 

Graphically, we can see that fixed costs have no relation to the volume of automobiles produced by the company. No matter how high or low sales are, fixed costs remain the same. Variable

Variable costs, on the other hand, show a linear relationship between the volume produced and total variable costs.

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Financial accounting vs managerial accounting

While financial accounting is required by law and mainly performed to benefit external users, managerial accounting is not required by law and is done to provide useful information to people within an organization, mainly management, to make better internal business decisions.

A clear comparison can be seen in the following table:

 

Financial AccountingManagerial Accounting
Purpose of informationTo communicate the company’s financial position to external users (i.e. investors, banks, regulators, government)To help management make better decisions to fulfill the company’s overall strategic goals
Primary usersExternal usersInternal (management)
Focus and emphasisPast orientedFuture oriented
Time spanAnnual or quarterly financial reports depending on companyVaries from hourly to years of information

 

 

Variable Costs vs Fixed Costs

The table below summarizes the key difference between fixed and variable costs:

 

Variable CostFixed Cost
DefinitionCosts that vary/change depending on the company’s production volumeCosts that do not change in relation to production volume
When production increasesTotal variable costs increaseTotal fixed cost stays the same
When production decreasesTotal variable costs decreaseTotal fixed cost stays the same
ExamplesDirect Materials (i.e. kilograms of wood, tons of cement)

Direct Labor (i.e. labor hours)

Rent

Advertising

Insurance

Depreciation

 

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Fixed and variable costs example #1

The following table shows various variable and fixed costs incurred by a manufacturing company:

 

CostVariableFixed
Depreciation of executive jetx
Cost of shipping finished goods to customersx
Wood used in manufacturing furniturex
Sales manager’s salaryx
Electricity used in manufacturing furniturex
Packing supplies for shipping productsx
Sand used in manufacturing concretex
Supervisor’s salaryx
Advertising costsx
Executive’s Life insurancex

 

 

Fixed vs variable costs example #2

Let’s stay 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 the company’s level of production.

 

Number of automobiles producedVariable Cost per Steering WheelTotal Variable CostTotal Fixed Cost
1$250$250$550,000
500250125,000550,000
1,000250250,000550,000
1,500250 

 

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Applications of Variable and Fixed Costs

Classifying costs as either variable or fixed is important for companies because by using the total variable costs and fixed costs, 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 to reduce these high variable costs and incur more fixed costs instead.

These decisions however also need to consider how many products are actually being sold. If the company invested in machinery and incurred high fixed costs, it would only be beneficial in a situation where sales are high to the extent that the overall fixed costs are cheaper than the total labor costs had the machine not been purchased.

If sales were low, even though unit labor costs remain high, it would be wiser to not invest in machinery and incur high fixed costs because low sales multiplied by high unit labor cost would still be lower than the overall fixed cost of the machinery.

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.

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More accounting resources

We hope this has been a helpful guide to fixed vs variable costs and how to use them in both management accounting and financial analysis.  To learn more, check out these additional resources below: