What are Variable Costs and Fixed Costs?
As a business owner, you should have heard of variable costs and fixed costs before. However, do you know what they actually mean? Determining them is crucial if you wish to be on top of the finances of your business. So, do not hesitate to seek help from an accounting firm in Johor Bahru if you are struggling to calculate them.
Let us have a look at both variable costs and fixed costs:
Variable costs are the costs that would change as the number of products manufactured or the number of services offered to vary. A company would not have any variable cost if it has not produced any products or provided any services. Variable costs would increase as the products manufactured or the services offered increase. If you want to calculate the total variable costs for your company, you need to work out the variable cost per unit, then multiply the sum with the sum of units that you have produced.
People would typically include direct materials as a variable cost. On the other hand, if the company does not add labour to, or minus labour from the manufacturing process when the quantity of production varies, then direct labour may not be considered as the company’s variable cost. Most of the overhead expenses are not included in variable costs. Thus, to calculate the variable costs correctly, you need to have some knowledge regarding the categorisation of costs.
The expenses of a company will change in direct proportion to its revenues if the company has high variable costs in its cost structure. This means that they will observe an increase in its revenue if its expenses increase. Such a situation makes it easier for the business owner to forecast or detect the company’s downturn compared to those businesses with a high fixed cost.
Fixed costs are the costs that will not change together with any business activities. This means that the company needs to pay for it repeatedly, even though it does not carry out any business activities. Most business owners would use this concept in financial analysis for them to identify the pricing of their products, as well as to find out the company’s breakeven point.
For instance, no matter whether the business owners have carried out business activities in the office or the factory, the building’s rental will not change unless the contract term is revised, or the lease expires. Property taxes, as well as depreciation, are some other examples of fixed costs. Such costs tend to incur regularly, and thus, business owners should consider them as period costs (Also see Understanding Product Costs and Period Costs). The sum that the business owners need to charge to expense would not change much from one accounting period to another.
For a company with a high proportion of the fixed cost, it needs to have high sales volume so that it has enough contribution margin for it to offset the fixed cost. However, as it reaches the sales level, its variable cost per unit will usually be low. This enables it to earn a substantial amount of profit above the breakeven point.
On the contrary, for a company with a low proportion of the fixed cost, its variable cost per unit may be high. Under such a situation, it will be able to generate profits when its sales volume is low. Nevertheless, as its sales increase, it will not be able to earn a substantial amount of profits.