When producing goods and services, a company must pay two main types of costs: variable costs and fixed costs. As the name suggests, variable costs may change depending on the total output produced, whereas fixed costs remain constant, regardless of the total output produced by the company. The difference between fixed and variable costs (business expenses) can have a big impact on the profitability of your business.
The Definition of Variable Costs
Variable costs are a company’s costs that come hand in hand with the number of goods or services it produces. It will increase or decrease depending on the production volume. If the production volume goes up, the variable costs will increase. The reverse will happen when the production volume goes down.
Let’s say you are a ceramic mug manufacturer that spends two dollars to produce each mug; then, if you produce 500 mugs each day, you will need to pay 1,000 dollars, whereas if you produce 1,000 mugs each day, you will need to pay 2,000 dollars. These are variable costs that depend on your total output, as mentioned above. Examples of variable costs include raw materials and packaging for production, wages for labourers, and delivery or shipping costs.
It is important to keep in mind that variable costs tend to differ across different industries and sectors. Manufacturing a car and manufacturing ceramic mugs will have two vastly different sets of variable costs. Surely, manufacturing a car will need a bigger budget than manufacturing a mug. Therefore, it is not comparable. When comparing two variable costs, make sure that it is from the same industry to better understand the variable costs that you will incur.
The Definition of Fixed Costs
Fixed costs are a constant outflow in every business, meaning that it is the type of expenses that needs to be paid regardless of the production volume; it is unavoidable for all companies. This is in stark contrast to the variable costs that align with the total goods you produce.
Harking back to the ceramic mug example, a fixed cost will be the machine needed to make the ceramic mugs. For instance, if the monthly rental of the machine costs $10,000, you will still need to pay that expense even if you do not produce a single mug for that month.
The same payment will also be paid if you make 1 million cups that month. Fixed costs refer to the expenses that remain the same to be paid regularly. Examples of fixed costs include lease and rent payments, insurance, or salaries for management.
However, the more products you produce will impact your overall bottom line and fixed costs. For example, if you lease a 10,000/month factory and make 1,000 mugs per month, the fixed cost can be spread out to $10 a mug. If you produce 10,000 cups, the fixed cost will be only $1 a mug.
It is crucial to note that both variable and fixed costs will increase as time goes on. This happens because of the yearly inflation, meaning the general increase in prices of goods and services. It is predicted that hyperinflation may happen soon due to the COVID-19 pandemic.
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