Definition of Fixed vs Variable Cost
Fixed Costs are business expenses that remain constant regardless of production or sales volume. Examples include rent, salaries, and insurance.
Variable Costs fluctuate with the level of output or sales. Examples include raw materials, packaging, and direct labor.
In accounting and economics, understanding the difference is crucial for cost control, pricing, and profit planning.
Meaning in Detail
Every business incurs costs to operate. These costs are broadly divided into fixed and variable:
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Fixed costs stay unchanged even if a company produces nothing. They are linked to the passage of time and not to activity levels. For instance, rent remains the same whether a factory makes 10 units or 1,000 units.
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Variable costs rise or fall depending on production. If more products are made, raw material and electricity costs increase. If production slows down, these costs decline.
The mix of fixed and variable costs shapes the cost structure of a business and influences pricing, break-even analysis, and long-term profitability.
Sub-Sections for Clarity
Fixed Costs
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Do not vary with production.
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Examples: Lease payments, depreciation, insurance.
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Predictable and easy to budget.
Variable Costs
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Change directly with production or sales volume.
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Examples: Raw materials, shipping, direct labor.
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Flexible but harder to predict.
Semi-Variable (Mixed) Costs
Some costs have both fixed and variable components (e.g., utility bills with a fixed base fee plus variable usage charges).
Formula for Fixed vs Variable Cost
Total Cost (TC) = Fixed Cost (FC) + Variable Cost (VC)
Where:
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FC = Constant expenses (e.g., rent)
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VC = Cost per unit × Number of units produced
Example Calculation
Suppose a company manufactures 1,000 units:
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Fixed Costs = ₹50,000 (rent, insurance, etc.)
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Variable Cost per unit = ₹100
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Total Variable Cost = ₹100 × 1,000 = ₹100,000
Total Cost = ₹50,000 + ₹100,000 = ₹150,000
Journal Entry (Accounting Example)
When incurring fixed and variable costs:
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Fixed Cost (Rent Expense):
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Variable Cost (Raw Materials Purchased):
Illustration with Calculation
Assume:
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Rent = ₹40,000
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Depreciation = ₹10,000
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Raw Material per unit = ₹20
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Units Produced = 2,000
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Fixed Cost = ₹50,000
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Variable Cost = 2,000 × ₹20 = ₹40,000
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Total Cost = ₹90,000
If sold at ₹70 per unit, Revenue = ₹140,000.
Profit = Revenue – Total Cost = ₹50,000.
Key Features of Fixed and Variable Costs
Fixed Costs
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Independent of production volume
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Time-bound expenses
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Predictable budgeting
Variable Costs
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Directly proportional to activity
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Fluctuate with production levels
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Harder to forecast but easier to control
Importance in Business
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Pricing decisions: Helps set selling price.
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Break-even analysis: Determines minimum sales needed for profit.
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Cost management: Businesses optimize their cost structure.
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Investment decisions: Knowing fixed obligations helps assess risk.
Advantages and Disadvantages
Fixed Costs
✔ Stability in planning
✔ Easier to forecast
✘ Risky during low sales
✘ High fixed costs = high break-even point
Variable Costs
✔ Flexible with production
✔ Lower risk when demand falls
✘ Harder to predict
✘ Can increase sharply with demand surge
Usage of Fixed vs Variable Costs
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Cost-Volume-Profit (CVP) Analysis
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Budgeting & Forecasting
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Performance Evaluation
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Decision-Making (make or buy decisions)
Case Studies
Case Study 1: Airline Industry
Airlines have high fixed costs (aircraft leases, staff salaries) and variable costs (fuel, meals). Efficient load factor utilization is crucial.
Case Study 2: E-commerce Company
An online store has fixed costs (server hosting, salaries) and variable costs (packaging, shipping). Scaling up reduces per-unit cost due to spreading fixed costs.
Table: Comparison of Fixed vs Variable Costs
| Basis | Fixed Cost | Variable Cost |
|---|---|---|
| Dependency | Independent of output | Varies with output |
| Examples | Rent, Insurance, Salaries | Raw Materials, Freight |
| Control | Difficult to reduce quickly | Easier to adjust |
| Forecasting | Predictable | Uncertain |
Practical Example
A bakery pays ₹30,000 rent monthly (fixed) and spends ₹20 per loaf on ingredients (variable).
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Producing 500 loaves = ₹10,000 variable cost.
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Total Cost = ₹30,000 + ₹10,000 = ₹40,000.
Common Mistakes or Misunderstandings
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Assuming all costs are fixed or variable (many are mixed).
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Ignoring depreciation as a fixed cost.
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Overestimating savings when reducing production (fixed costs remain).
Real-Life Applications
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Startups keep fixed costs low to reduce risk.
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Manufacturers monitor variable costs for efficiency.
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Legal Implications: Lease contracts (fixed obligations) can affect bankruptcy or restructuring cases.
FAQs
Q1: Are salaries fixed or variable costs?
Some salaries are fixed (monthly wages), while hourly wages linked to production are variable.
Q2: Why is understanding fixed vs variable cost important?
It helps in pricing, budgeting, and profit planning.
Q3: Can costs change category over time?
Yes, costs can shift (e.g., outsourcing may turn a fixed salary cost into a variable expense).
Expert Tip from Learn with Manika
“Always analyze your cost structure before expansion. A balanced mix of fixed and variable costs reduces risk and maximizes profitability.”
Related Terms
- Contribution Margin
- Break-Even Analysis
- Cost Structure
- Overhead Costs
- Operating Leverage