Business, Legal & Accounting Glossary
Fixed costs refer to the costs that do not change despite changes in production or amount of goods sold. These include insurance, property tax, interest expenses, and rent. These costs remain fixed regardless of changes in production. Such type of cost is very common in short-run production.
The determination of the difference in the variable and fixed cost is necessary as it plays a vital role in devising the ways of maximizing profits. While making production plans fixed costs hardly make an impact as they are constant.
However, fixed costs are not akin to sunk costs. They are constant but are not invariants. They might change. They are fixed with respect to production for a fixed period of time. A high rate of fixed costs leads to increased operational gearing. The term, however, has a different usage in management accounting and business planning.
In cost accounting, a part of management accounting, fixed costs are expenses that do not change in proportion to the activity of a business, within the relevant period or scale of production. For example, a retailer must pay rent and utility bills irrespective of sales. Unit fixed costs, called average fixed costs (AFC), decline with volume, following a rectangular hyperbola as the inverse of the volume of production: AFC = FC/N.
Variable costs by contrast change in relation to the activity of a business such as sales or production volume. In the example of the retailer, variable costs may primarily be composed of inventory (goods purchased for sale), and the cost of goods is therefore almost entirely variable. In manufacturing, direct material costs are an example of a variable cost. An example of variable costs are the prices of the supplies needed to produce a product.
Along with variable costs, fixed costs make up one of the two components of total cost. In the most simple production function, total cost is equal to fixed costs plus variable costs.
In microeconomics and business, the difference between fixed costs and variable costs (and the related terms average cost and marginal cost) is crucial, as each will influence production decisions for profit maximization differently. In the most simple cases, fixed costs do not affect production decisions, because they cannot be changed, and management will choose to produce if sales prices are above the cost of each additional unit (marginal cost).
Fixed costs should not be confused with sunk costs. From a pure economics perspective, fixed costs may not be fixed in the sense of invariate; they may change, but are fixed in relation to the quantity of production for the relevant period. For example, a company may have unexpected and unpredictable expenses unrelated to production, and these would not be considered part of variable costs.
It is important to understand that fixed costs are “fixed” only within a certain range of activity or over a certain period of time. If enough time passes, all costs become variable. Similarly, not all indirect costs are fixed costs; for example, advertising expenses or labour costs are indirect costs that are variable over a slightly longer time frame, as they may not be subject to change in the short term, but maybe easily adjustable over a longer time frame. For example, a firm may not be able to vary the number of employees (and hence labour costs) in the short term due to contract obligations, but be able to lay employees off or otherwise change these costs.
In accounting terminology, fixed costs will broadly include all costs (expenses) which are not included in the cost of goods sold, and variable costs are those captured in costs of goods sold. The implicit assumption required to make the equivalence between the accounting and economics terminology is that the accounting period is equal to the period in which fixed costs do not vary in relation to production. In practice, this equivalence does not always hold, and depending on the period under consideration by management, some overhead expenses (such as sales, general and administrative expenses) can be adjusted by management, and the specific allocation of each expense to each category will be decided under cost accounting.
In business planning and management accounting, usage of the terms fixed costs, variable costs and others will often differ from usage in economics and may depend on the intended use. For example, costs may be segregated into per-unit costs (costs of goods sold), fixed costs per period, and variable costs as a proportion of revenue. Capital expenditures will usually be allocated separately, and depending on the purpose, a portion may be regularly allocated to expenses like depreciation and amortization and seen as a fixed cost per period, or the entire amount may be considered upfront fixed costs.
Variable costs fluctuate with a change in production output and sales. Fixed costs and variable costs form two important constituents of the total cost. In a state of a normal production function, the sum of variable and fixed costs make up the total cost.
The average cost is the total cost divided by the number of units produced. It is the summation of average fixed cost and average variable cost in the short run.
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This glossary post was last updated: 23rd April, 2020 | 9 Views.