Fixed and variable costs are categories of costs based on activity level. Fixed costs are expenses that don’t change regardless of changes in activity level, whereas variable costs respond directly to activity level changes. Distinguishing between fixed vs variable costs help in determining your business’s contribution margin (CM).
Fixed vs Variable Cost Examples
| Fixed Costs | Variable Costs |
|---|---|
|
|
The list above isn’t exhaustive. Every industry will have unique kinds of costs—and a fixed cost for one industry may be variable for another and vice versa.
Most costs are pretty easy to classify as fixed or variable through logic. If you increase production, do you expect that total cost to increase? If yes, then it is a variable cost. Other costs are trickier and likely contain components of both fixed and variable cost. These are called mixed costs, and we’ll discuss that more later in the article.
Behavior of Fixed and Variable Costs
Knowing how fixed and variable costs behave is key to understanding how costs affect your business in general and how to determine contribution margin. In this analysis, we will try to see how different activity levels affect fixed and variable costs.
Rules in Cost Behavior:
- Fixed costs remain constant in total and vary per unit.
- Variable costs remain fixed per unit and vary in total.
- The behavior of costs are only valid within the relevant range (defined below).
In analyzing cost behavior, understanding the concept of the relevant range is crucial in distinguishing fixed from variable cost. The relevant range refers to the minimum and maximum amount that a business can produce goods and services wherein all cost relationships remain valid.
Cost relationships are valid when variable costs remain variable and fixed costs remain fixed. If you go outside the relevant range, it’s possible that all costs will be variable and, at some point, some variable costs will become fixed. That’s why determining the relevant range is important in this analysis.
Variable Cost Behavior
To compute total variable costs, we simply multiply the variable cost per unit by the activity level.
| Activity Level (Units) | 100 | 200 | 300 | 400 | 500 |
|---|---|---|---|---|---|
| Variable Cost per Unit | $10 | $10 | $10 | $10 | $10 |
| Total Variable Cost | $1,000 | $2,000 | $3,000 | $4,000 | $5,000 |
Pay attention to the variable cost per unit. Regardless of activity level, it remains at $10 per unit. But if you look at the total, variable costs increase as activity levels increase. We can say that the activity level and variable cost have a direct relationship.
In summary, total variable costs always respond to activity level. To control total variable costs, you must decrease variable costs on a per-unit basis.
For example, you can control variable costs by redesigning your production process to decrease the amount of labor or materials that goes into each unit of production. When considering only variable costs, you cannot increase profit by increasing production.
Fixed Cost Behavior
Fixed costs, on the other hand, are always in total amount. Hence, we divide total fixed costs by the activity level to determine the fixed cost per unit.
| Activity Level (Units) | 100 | 200 | 300 | 400 | 500 |
|---|---|---|---|---|---|
| Total Fixed Cost | $5,000 | $5,000 | $5,000 | $5,000 | $5,000 |
| Fixed Cost per Unit | $50 | $25 | $16.70 | $12.50 | $10 |
We can see that fixed costs remain constant regardless of the number of units produced. However, we should look at the fixed cost per-unit amount to see how activity level impacts fixed costs. If we produce 100 units, each unit has $50 of fixed costs in it. But if you boost production to 500 units, each unit will get only $10 of fixed costs.
Total fixed costs remain constant in all activity levels, but fixed costs per unit decrease if you produce more goods. Hence, the economies of scale apply, and you can increase your profit per unit by increasing production. Since costs spread more on higher production levels, you can reduce fixed costs per unit by producing more.
However, increasing production is not always a solution to achieve lower fixed costs. You should consider other factors such as product demand, production capacity, and storage costs, to name a few.
What Mixed Costs Are
Sometimes, it may be difficult for you to classify business expenses as fixed or variable in nature. These expenses seem to increase with activity level but remain constant at some point. These expenses are called mixed costs because they have fixed and variable components.
If you encounter mixed costs, you need to separate them first into fixed and variable costs to determine CM. Mixed costs are expressed algebraically as:
y = a + bX
Where:
- y = total cost (dependent variable)
- a = total fixed cost (constant or y-intercept)
- b = variable cost per unit (slope)
- X = activity level (independent variable)
In cost accounting, mixed costs are always expressed in total values. Management accountants use the linear regression method to separate fixed and variable components. However, a much simpler approach is the high-low method:
- The linear regression method provides more approximate results than the high-low method. Under linear regression, all values are considered in finding the nearest linear relationship.
- The high-low method only considers the highest and lowest values that depict a linear relationship.
Let’s assume that your company is deciding how many electric components should be produced. Regardless of the volume, each batch would cost $2,000, which includes machine setup costs, materials moving, and materials preparation. Each electronic component would cost $12 to produce.
| 100 Units of Production | 200 Units of Production | |
|---|---|---|
| Total Cost | y = a + bX y = 2,000 + (12)(100) y = 2,000 + 1,200 y = $3,200 | y = a + bX y = 2,000 + (12)(200) y = 2,000 + 2,400 y = $4,400 |
| Unit Cost | Unit cost = Total cost ÷ Production Unit cost = 3,200 ÷ 100 units Unit cost = $32 each | Unit cost = Total cost ÷ Production Unit cost = 4,400 ÷ 200 units Unit cost = $22 each |
Based on the computation above, we can immediately say that it’s costly to produce more units, and your company would need more resources to start production. But if we look at the per-unit cost, it’s actually $10 cheaper to produce 200 units than 100 units. Assuming all things are constant, we should produce 200 units for a lower unit cost.
Calculating & Understanding Contribution Margin
CM is called “contribution margin” because it is the amount available from the sale of each unit to “contribute” to cover all fixed costs and desired profit. It is calculated as follows:
CM per unit = Sales price – Variable COGS per unit
You cannot determine CM if you haven’t distinguished fixed from variable costs. That’s why you first need to look at your cost structure before diving into CM analysis. Understanding CM helps you determine what is necessary to maximize your profitability. The first step in maximizing profitability is to maximize your CM by reducing variable costs.
Note that CM is not the same as gross profit (GP) because CM only recognizes the variable components of expense while GP includes both fixed and variable expenses. To learn more about gross profit, our comparison of revenue vs profit discusses gross profit in greater detail.
Computing CM is only a matter of segregating variable from fixed costs, but the overall net income remains the same if compared with a traditional income statement presentation.
CM Income Statement
Notice that we segregated all variable and fixed costs in computing CM and operating income. All variable costs are deducted from sales regardless of whether they are direct or indirect costs. Take note of the items in yellow before you check the traditional income statement presentation.
| Sales | $40,000 |
|---|---|
| Direct Materials | ($8,000) |
| Direct Labor | ($7,000) |
| Variable Selling Expenses | ($4,000) |
| Contribution Margin | $21,000 |
| Fixed Manufacturing Overhead | ($8,400) |
| Fixed Selling & Administrative Expenses | ($5,000) |
| Operating Income | $7,600 |
Traditional Income Statement
Under the traditional method, all costs related to production—whether fixed or variable—are deducted directly from sales and referred to as COGS. In our example below, we can see that fixed manufacturing overhead is part of gross margin even if it is fixed. But if you look at variable selling expenses, it is no longer part of COGS because it is not related to production even if it is a variable cost.
| Sales | $40,000 |
|---|---|
| Direct Materials | ($8,000) |
| Direct Labor | ($7,000) |
| Fixed Manufacturing Overhead | ($8,400) |
| Gross Margin | $16,600 |
| Fixed Selling & Administrative Expenses | ($5,000) |
| Variable Selling Expenses | ($4,000) |
| Operating Income | $7,600 |
Regardless of the method of presentation, operating income remains at $7,600.
Frequently Asked Questions (FAQs)
Fixed and variable costs are both components of total costs. If you add fixed and variable costs, you arrive at the total cost. Fixed costs remain constant regardless of production level within the relevant range while variable costs increase or decrease based on production level.
Yes, because it helps maximize profitability. Variable costs are managed primarily by controlling the direct labor and materials that go into each unit of production. If variable costs exceed your sales price, increasing production will decrease your profit or increase your loss. However, if you’re showing negative net income due to fixed costs, increasing production can produce a profit because fixed costs remain the same.
Bottom Line
Distinguishing fixed vs variable costs and how it relates to contribution margin is a useful tool for decision-making. You can use this information to assess resource management and to determine a competitive price in the market.
