The Difference between Fixed Cost and Variable Cost
The primary difference between fixed cost and variable cost is that the former remains level while the latter changes according to the activity of a company or, more specifically, the volume of production. Examples of fixed costs, also called “sunk costs” because they must always be paid, include rent, insurance, and leasing fees, while a business’ variable costs would likely include things like raw materials and commissions.
Even though fixed costs are juxtaposed with variable costs according to the aforementioned rule of thumb, the truth is that fixed costs can alter over time. For this reason, they are sometimes referred to as “period costs.” These period costs might include advertising or marketing fees that are paid regularly on a monthly or quarterly basis, but which increase over time with inflation or according to changes in the external marketing company. Even though these rates change, they are still considered fixed because they must be paid out regardless of sales activity.
Shoe Store Example: Fixed Costs
The difference between fixed cost and variable cost might be illuminated with the help of an example. Consider, for instance, the day-to-day business of a shoe company. One branch of this company rents out space in a local mall on which it has also taken out rental insurance. The branch manager has also leased a truck with which to make deliveries to other branches. All of these expenses would be considered fixed costs because they must be paid out to the building owner, insurance company, and leasing company, regardless of whether or not any shoes are sold at all.
Shoe Store Example: Variable Costs
Imagine, however, that the branch manager of this same shoe store has also hired several new employees, in response to a recent upsurge in customer traffic. Additionally, the manager has put in an order for a wider variety of shoes in order to meet the increased demand that has arisen with a widened customer base. He or she has also had to pay out more in shipping costs for online orders. All of these expenses would be documented as the store’s variable costs, because they are reliant on the activity and output of the store, and are controlled by managerial oversight.
Reducing Fixed Rates
While increased variable rates are not necessarily a bad sign, as they may reflect added business and increased activity, fixed rate percentages should ideally be kept as low as possible. Sports stadiums, movie theaters, and gas stations attempt to do this by increasing the variety of services available. The goal is to decrease the ratio of fixed cost to units sold. For example, a gas station will pay the same property taxes when it sells only gas as it does when it sells gas and convenience store items; however, in the latter case, the revenue will more greatly exceed the fixed cost.
Regardless of the strategies employed to improve the ratio of revenue to fixed cost, accountants and store managers should pay close attention to the relative percentages of fixed and variable costs compared to overall income. This will make them better able to estimate future profit and/or determine how to improve sales. The difference between fixed cost and variable cost is easy to understand once you have seen real life examples of how this works.