When it comes to categorizing expenses, most accountants must deal with distinguishing between variable costs and fixed costs. When done right, the process is simple; however, there are various aspects to consider along the way. In this article, we’ll simply explain everything you need to know about the matter with hands-on examples.
An Overview Of Variable Costs vs. Fixed Costs
A company's expense when producing its goods or performing its services is referred to as a cost. Simply put, it is the amount of money that businesses invest in buying and selling products. Variable and fixed costs are the two primary categories of expenses businesses have.
That cost outlays don't change regardless of how much a business produces. These expenses, which might include items like rent, property tax, insurance, and depreciation, are typically unrelated to a company's specific business operations.
Expenses that vary according to how much a business produces and sells are considered variable costs. Consequently, variable costs grow with rising production and diminish with falling production. Labor, utility prices, commissions, and raw materials are some of the most typical categories.
- Businesses usually incur both variable and fixed costs during the production process.
- The amount of product generated determines the fluctuation in variable costs.
- Raw materials, labor, and commissions are examples of variable expenses.
- Regardless of the level of production, fixed expenses stay constant.
- Lease and rental payments, insurance, and interest payments are examples of fixed costs.
Variable Costs Simply Explained
Any expenses a business has that are based on the volume of products or services it produces are referred to as variable costs. Variable costs fluctuate with an organization's production volume. The variable costs rise together with the growth in production volume but decrease if the quantity decreases.
As mentioned above, typical instances of variable expenses include:
- Utility costs
- Resources for production
By multiplying the output volume by the variable cost per unit of production, variable costs can be calculated. For example, let's say that Wasslak sells stickers for SAR 4 each. The corporation will incur a variable cost of SAR 2,000 if it produces 1,000 units.
Total Variable Costs = Cost Per Unit x Total Number of Units
However, the corporation won't incur any variable expenses for manufacturing the stickers if it doesn't produce any units. Similarly to that, the price will go to SAR 4,000 if the business produces 2,000 units.
Variable costs change throughout industries, so it is crucial to keep in mind that comparing the variable costs of a vehicle manufacturer and an appliance manufacturer is completely useless.
That is due to the fact that their production output is incomparable. Therefore, choose businesses that are involved in the same industry if you want to compare the variable expenses between them. Semi-variable costs may also exist for businesses, made up of variable and fixed costs.
Fixed Costs Simply Explained
Whether or not goods or services are produced, fixed costs never change. In other words, a business cannot avoid fixed costs. As a result, unlike variable costs, a company's fixed expenses are indirect, meaning they often don't pertain to the manufacturing process and don't change with the production volume.
Lease and rent payments, property taxes, salaries, insurance, depreciation, and interest payments are typical of fixed costs. It’s also important to note that fixed costs are often called overhead costs.
Let's use the same company from above to illustrate. Suppose Wasslak pays a fixed monthly rental fee of SAR 20,000 for the equipment it uses to make stickers. Even if the business does not make any stickers throughout the month, it must still pay SAR 20,000 to rent the equipment.
However, the fixed cost will always be the same even if it makes a million stickers. In this case, the variable costs range from SAR 0 to SAR 4 million.
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A corporation must earn more income to break even with the more fixed costs it has, which implies it must work more to manufacture and sell its goods. This is because these expenditures are constant and rarely alter over time.
The effect of fixed expenses on a company's bottom line might vary depending on how many products it produces, while variable costs often remain constant, relatively speaking. Consequently, fixed costs decrease relatively as production rises. As a result, it is possible to spread the cost of more things over the same amount of a fixed cost. A corporation may gain economies of scale in this way by raising production and bringing down costs.
Let's retake the case of Wasslak, which manufactures 2,000 stickers every month and pays SAR 20,000 monthly rent for its production site. As a result, it may divide the set rent expense at a rate of SAR 20 per sticker. However, the fixed cost of the lease drops to SAR 2 per sticker if it produces 20,000 stickers per month.
Are Marginal Costs And Variable Costs The Same Thing?
Any company expense connected to producing an extra unit of output or providing service to an extra client is referred to as a marginal cost. Because it increases progressively to make one additional product, a marginal cost is the same as an incremental cost. Variable costs are an element of the production process and an expense simultaneously. Thus they can be categorized as marginal expenses.
There is also a marginal cost included in the overall cost of production because variable expenses alter depending on the volume of production.
How Can Variable Costs Be Lowered?
A company can lower its variable costs in a variety of ways. For instance, if the quality of the products is not compromised, increasing output while utilizing the same quantity of material can significantly reduce expenses.
In addition, creating a new production process, which can involve implementing new or enhanced technological procedures or equipment, might aid in reducing variable costs. If this isn't practicable, management may review the procedure to find areas for efficiency and improvement, which can lower certain variable expenses like labor and utilities.
Costs are undoubtedly vital parts of every business, be it service or good based. Therefore, correctly distinguishing between variable and fixed costs is of the utmost importance to all accountants who want to keep their books in order. If you’re among them and would like to expand or strengthen your knowledge about expenses, check out one of our related articles—see you there!
Read our short guide on how to record your expenses on Wafeq.