Costs are an essential part of management accounting. They represent a monetary value that companies or businesses spend on producing a product or service. For advanced analysis, companies may classify their costs based on several factors. For example, companies can categorize them based on nature, element, behaviour, or function.
When classifying costs by behaviour, companies evaluate how each cost changes due to their level of activity. Through this, companies can identify whether a cost is fixed or variable. While both contribute to a product’s costs, there are some differences between both.
What is a Variable Cost?
A variable cost is a cost that changes in relation to the level of activity of a company. There is a direct relationship between a company’s activity levels and its variable costs. When activity levels raise, the total variable costs will also increase. Examples of variable costs include direct material and labour used in the production process.
Since these costs change according to the level of activity, they differ from fixed costs. However, variable costs stay constant per unit. It means that even though activity levels may vary, the value of variable costs that goes into a single product unit will not change. It is another characteristic that differentiates variable costs from fixed costs.
For example, a company requires $20 direct material and $10 direct labour costs to manufacture a product. If the company produces 1,000 units of the product, its variable costs will be $30,000. If it produces 10,000 units, they will be $300,000. However, the cost per unit in both cases will stay the same, $30.
What is a Fixed Cost?
A fixed cost is a cost that does not change with fluctuations in a company’s level of activity. Regardless of how many units of a product or service a company produces, these costs will stay fixed. There is no relationship between the total fixed costs and activity levels of a company. Examples of fixed costs include factory rent, executive salaries, advertising, insurance, etc.
Unlike the variable costs, per unit fixed costs don’t remain constant. As a company’s level of activity increases, its fixed costs will decrease. It is a concept known as economies of scale. As companies expand their product, the fixed costs spread over a higher number of units. Therefore, these decrease as companies increase their production. Hence, the more units a company produces, the more it can recover its fixed costs.
For example, a company pays a rent of $10,000 for its factory building. Regardless of whether it produces 1,000 or 10,000 units, the total rent will stay fixed. However, if the company makes 1,000 units, the rent cost absorbed per unit will be $10/unit ($10,000 / 1,000 units). Alternatively, if the company produces 10,000 units, the rent absorbed per unit will be $1/unit ($10,000 / 10,000 units).
Why do companies classify costs as Variable or Fixed?
Classifying costs can have various advantages. Firstly, companies need to identify their variable costs to calculate their Cost of Goods Sold. Similarly, the classification helps in better decision-making within a company. For example, companies making high gross income, but net losses can identify fixed costs to reduce. Lastly, companies need to differentiate between costs for various management accounting related calculations, such as marginal costing.
Companies can classify their costs based on several factors. When they divide their costs according to behaviour, they can categorize them as variable or fixed. Total variable costs fluctuate with fluctuations in activity levels. However, total fixed costs stay the same regardless of activity levels.