Variable vs. Fixed Costs

In cost accounting, there are two basic ways costs behave: the product costs either increase as product output increases, or they remain static regardless of how much output is created. Many will wonder when this will get interesting, and to be quite frank, any blog post starting with “in cost accounting,” will most likely not get too exciting. It will, however, be important for business owners to understand profitability of a business.

By definition, a variable cost is an expenditure a company incurs where the total cost of a product or service changes in proportion to the volume or activity. For example, if an hourly employee performs 20 hours of services at cost rate of $100 per hour, the variable cost for that employee would be $2,000 (20 hours x $100 per hour). The total amount of the cost to employ the particular employee is proportionate to how many hours the employee works.

On the contrary, a fixed cost is also an expenditure that the company incurs but the total cost of a product or services remain the same despite the changes in volume or activity. An example would be a salaried employee who works 40 hours one week and 50 hours the next would cost the company the same amount to employ that individual for both weeks. It is important to note that as volume or activity increases, the unit cost decreases. For example, if a salaried employee works 20 hours one week, their salary remains the same at $3,000 but the hourly cost is $150 per hour ($3,000 / 20 hours). Likewise, if the same salaried employee works 40 hours another week, their salary also remains the same but the hourly cost is $75 per hour ($3,000 / 40 hours).

Below is a graph comparing the difference between a variable cost and a fixed cost:

There are different benefits in choosing to go with a variable or fixed cost. One benefit in selecting variable costs is that companies will incur an expense on an as-needed basis. Similar to the example given above, if a company only needs 20 hours of general administrative support, 20 hours times the individual’s cost rate would be their expense. This variable cost would be significantly lower had the company opted to go with a fixed cost option. Fixed cost benefits could include possibly better quality of service provided and an increase of employee loyalty towards the company.

The importance of knowing variable costs versus fixed costs is the fact that it affects the bottom line. Costs will determine whether a company has net income or net loss as it affects the cost of goods sold, sales, general, and administrative accounts in the income statement.

Written by:
Erika Marasigan
TGG Accounting
 
 
Reference:
Horngren, C. T., Datar, S. M., & Foster, G. (2006). Cost Accounting: A Managerial
Emphasis. (12 ed.). New Jersey: Pearson Education.
 
 
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