Variable and Fixed Costs

variable costsVariable costs are corporate expenses that vary with production output. Variable costs are those costs that vary depending on a company’s production volume; they rise as production increases and fall as production decreases. Variable costs differ from fixed costs such as rent, advertising, insurance and office supplies, which tend to remain the same regardless of production output. Fixed costs and variable costs comprise total cost.

Variable costs can include direct material costs or direct labor costs necessary to complete a certain project. For example, a company may have variable costs associated with the packaging of one of its products. As the company moves more of this product, the costs for packaging will increase. Conversely, when fewer of these products are sold the costs for packaging will consequently decrease.

The variable costs ratio is an expression of a company’s variable production costs as a percentage of sales, calculated as variable costs divided by total revenues. It compares costs that change with levels of production to the amount of revenues generated by production. This contrasts with fixed costs that remain constant regardless of production levels.

Consideration of the variable costs ratio, which can alternately be calculated as 1 – contribution margin ratio, is one factor in determining profitability, since it indicates if a company is achieving, or maintaining, the desirable balance where revenues are rising faster than expenses.

The variable costs ratio quantifies the relationship between revenues and the specific costs of production associated with the revenues. It is a useful evaluation metric for a company’s management in determining necessary minimum profit margins, making profit projections and in identifying the optimal sales price for a product as part of price setting.

The variable costs calculation can be done on a per-unit basis, such as a $10 variable cost for one unit with a sales price of $100 giving a variable cost ratio of 0.1 or 10%, or by using totals over a given time period, such as total monthly variable costs of $1,000 with total monthly revenues of $10,000 also rendering a variable cost ratio of 0.1 or 10%.

Fixed Cost

A fixed cost is a cost that does not change with an increase or decrease in the amount of goods or services produced or sold. Fixed costs are expenses that have to be paid by a company, independent of any business activity. It is one of the two components of the total cost of running a business, along with variable cost.

A fixed cost is an operating expense of a business that cannot be avoided regardless of the level of production. Fixed costs are usually used in breakeven analysis to determine pricing and the level of production and sales under which a company generates neither profit nor loss. Fixed costs and variable costs form the total cost structure of a company, which plays a crucial role in ensuring its profitability.

Accountants perform extensive analysis of different expenses to determine whether they are variable or fixed. Higher fixed costs in the total cost structure of a company require it to achieve higher levels of revenues to break even. Fixed costs must be incurred regularly, and they tend to show little fluctuations from period to period. Examples of fixed costs include insurance, interest expense, property taxes, utilities expenses and depreciation of assets. Also, if a company pays annual salaries to its employees irrespective of the number of hours worked, such salaries must be counted as fixed costs. A company’s lease on a building is another common example of fixed costs, which can absorb significant funds especially for retail companies that rent their store premises.

A business must incur variable and fixed costs to produce a given amount of goods. Variable costs per item stay relatively flat, and the total variable costs change proportionately to the number of product items produced. Fixed costs per item decrease with increases in production. Thus, a company can achieve economies of scale when it produces enough goods to spread the same amount of fixed costs over a larger number of units produced and sold. For example, a $100,000 lease spread out over 100,000 widgets means that each widget carries with it $1 in fixed costs. If the company produces 200,000 widgets, the fixed cost per unit drops to 50 cents.

Companies with large fixed costs and unchanged variable costs in their production process tend to have the greatest amount of operating leverage. This means that after a company achieves the breakeven point, all else equal any further increases in sale will produce higher profits in proportion to sales increase for a company up to a point where fixed costs per unit sold become negligible. Conversely, decreases in sales volume can produce disproportionately higher declines in profits.

An example of companies with high fixed cost component are utility companies, which have to make large investments in infrastructure and have subsequently large depreciation expenses with relatively stable variable costs per unit of electricity produced.

 


 

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