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Fixed and Variable Costs

Introduction

Costs, when categorized according to behavior (in relation to changes in level of activity), can be classified into: (1) fixed costs and (2) variable costs.

In a Nutshell

Total variable costs increase as number of units (cost driver) increase. Variable costs per unit are constant.

Within a relevant range, total fixed costs are constant even if units increase. Fixed cost per unit decreases as units increase.

Mixed costs have elements of both fixed and variable costs. For better analysis of costs, mixed costs are often segregated into variable and fixed.

Variable Costs

Within the relevant range and specified time period, the total amount of variable costs varies directly (in proportion) to change in activity level. The cost per unit is constant.000

For example: ABC Company spends $2.50 materials cost for every unit of Product A. If the company produces 1,000 units, it spends $2,500 ($2.50 x 1,000). If it produces 2,000 units, then the company will spend $5,000 ($2.50 x 2,000). Take note that the cost per unit does not change but the total cost varies directly with the level of activity.

Total variable cost = Variable cost per unit x Number of units or activity

Common examples of variable costs include direct materials, direct labor, supplies, fuel and power, spoilage costs, receiving costs, royalties, overtime premium, sales commissions, and delivery expenses.

Fixed Costs

Within the relevant range, total fixed costs remain constant. Regardless of the level of activity, the business pays the same. However, the fixed cost per unit changes as the level of activity changes. As more units are produced, the fixed cost per unit decreases.

For example: ABC Company pays monthly rent of $30,000 for a factory building. Regardless of how many units are produced, the company pays the same amount. If we are to compute for the fixed cost per unit at 1,000 units, it would be equal to $30 ($3,000/1,000 units). If the company produces 1,500 units, then fixed cost per unit would be $20 ($3,000/1,500 units). As the level of activity increases, the fixed cost per unit decreases. The total fixed cost remains the same.

Examples of fixed costs include rent, depreciation, patent amortization, property insurance, property taxes, and fixed salaries of production executives and indirect labor.

Mixed Costs

Mixed costs contain both fixed and variable elements. The company pays a constant fixed cost and a variable amount on top of it. Examples of mixed costs include: utilities, repairs and maintenance, inspection, fringe benefits, employer's payroll taxes, and salaries that contain a fixed amount plus commissions.

Total cost = Fixed costs + Variable costs
Total cost = FC + (VC per unit x Number of units)

Example

XYZ Company has entered into several contracts that require it to pay fixed selling costs of $100,000 per month. The cost accountant determined the variable selling cost at $30 per unit. Compute for the total selling cost that would be incurred if the company expects to sell 2,500 units next month.

Solution:
Total cost = Fixed cost + Variable costs
Total cost = $100,000 + ($30 x 2,500)
Total cost = $175,000

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