The difference between fixed and variable costs

The difference between fixed and variable costs is that fixed costs do not change with activity volumes, while variable costs are closely linked to activity volumes. Thus, fixed costs are incurred over a period of time, while variable costs are incurred as units are produced.

This difference is a key part of understanding the financial characteristics of a business. If the cost structure is comprised mostly of fixed costs (such as an oil refinery), managers are more likely to accept low-priced offers for their products in order to generate sufficient sales to cover their fixed costs. This can lead to a heightened level of competition within an industry, since they all likely have the same cost structure, and must all cover their fixed costs. Once fixed costs have been paid for, all additional sales typically have quite high margins. This means that a high fixed-cost business can make very large profits when sales spike, but can incur equally large losses when sales decline.

If the cost structure is comprised mostly of variable costs (such as a services business), managers need to turn a profit on every sale, and so are less inclined to accept low-priced offers from customers. These businesses can easily cover their small amounts of fixed costs. Variable costs tend to comprise a relatively high proportion of sales, so the profits generated on each individual sale once fixed costs have been covered tend to be lower than under a high fixed cost scenario.

Examples of fixed costs are rent, insurance, depreciation, salaries, and utilities. Examples of variable expenses are direct materials, sales commissions, and credit card fees.

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