Lesson 28 - Beginner accounting course

28. Understanding Expenses: Fixed vs. Variable Costs

In accounting, expenses represent the costs incurred by a business to generate revenue. They are recorded on the income statement and play a crucial role in determining a company’s profitability. Understanding the difference between fixed and variable costs is essential for budgeting, pricing strategies, and financial planning.

What Are Expenses?

Expenses are the outflows of resources (usually cash or assets) that a company spends to operate its business. Common types of expenses include rent, salaries, utilities, raw materials, and advertising. Expenses are categorized into fixed costs and variable costs based on how they behave relative to changes in business activity.

Fixed Costs: Definition and Characteristics

Fixed costs are expenses that remain constant regardless of the level of production or sales. These costs do not fluctuate with business activity in the short term.

Key Characteristics of Fixed Costs:

• Remain constant over a given period.

• Not directly tied to production levels.

• Must be paid even if the business produces nothing.

• Spread over more units as production increases, lowering the per-unit cost.

Examples of Fixed Costs:

1. Rent or Mortgage – A company pays the same office or warehouse rent regardless of how much it produces.

2. Salaries – Permanent employees’ salaries remain unchanged, even if production fluctuates.

3. Insurance – Business insurance premiums are paid at a fixed rate.

4. Depreciation – The gradual reduction in value of fixed assets like machinery and vehicles is a non-cash fixed cost.

5. Loan Payments – Interest and principal payments on loans remain the same over time.

Variable Costs: Definition and Characteristics

Variable costs change based on the level of production or sales. When production increases, variable costs increase; when production decreases, these costs drop.

Key Characteristics of Variable Costs:

• Fluctuate with production and sales volume.

• Directly tied to business activity.

• Increase per unit of production.

• Can be controlled more easily compared to fixed costs.

Examples of Variable Costs:

1. Raw Materials – The cost of ingredients or components used in production (e.g., fabric for clothing manufacturers).

2. Direct Labor – Wages paid to temporary or hourly workers that depend on production volume.

3. Utilities (Partially Variable) – Electricity or water usage may rise with increased production.

4. Sales Commissions – Payments to salespeople based on the number of units sold.

5. Shipping Costs – Higher production and sales result in higher transportation expenses.

Comparison: Fixed Costs vs. Variable Costs

Mixed Costs (Semi-Variable Costs)

Some expenses contain both fixed and variable components. These are called mixed costs or semi-variable costs.

Examples of Mixed Costs:

• Utility Bills – A factory has a fixed electricity charge but also pays more when production increases.

• Salaries with Bonuses – A salesperson has a base salary (fixed) and earns commissions (variable).

• Vehicle Expenses – A delivery company pays a fixed lease cost for trucks, but fuel expenses vary based on usage.

Why Understanding Fixed and Variable Costs Matters

1. Profitability Analysis

   • Businesses must cover fixed costs before making a profit.

   • Higher variable costs can reduce profit margins.

2. Break-Even Analysis

   • A company reaches the break-even point when total revenue = total fixed + variable costs.

   • Helps determine how much needs to be sold to start making a profit.

3. Pricing Strategies

   • Companies must factor in both fixed and variable costs to price products profitably.

   • Businesses with high fixed costs (e.g., airlines, factories) need high sales volumes to stay profitable.

4. Budgeting and Cost Control

   • Fixed costs must be planned for in the long term.

   • Variable costs can be adjusted to respond to demand changes.

Key Takeaways

• Fixed costs remain constant regardless of production levels (e.g., rent, salaries).

• Variable costs fluctuate with production and sales volume (e.g., raw materials, commissions).

• Mixed costs have both fixed and variable components (e.g., utilities, some labor costs).

• Understanding these costs helps businesses set prices, control expenses, and maximize profitability.