Accounting concepts tend to be very confusing to the uninitiated. That’s rather unfortunate because in operating a business sooner or later you will bump into accounting concepts. One of the more confusing accounting concepts is that of fixed costs versus variable costs. So let’s discuss the differences between fixed and variable costs, what makes them fixed or variable and to what degree costs are fixed or variable.
The distinction between fixed and variable is usually applied in a branch of accounting known as management accounting. Most should be familiar with financial accounting (reporting) which is the production of financial statements for internal and external use by people such as shareholders and determining the tax due. Management accounting produces statements for internal use, such as cost-benefit analysis, break-even analysis and make or buy decisions. The idea here is that management needs to look at things a little differently to get an idea as to whether the business is performing well or it can continue in the event of shocks or changes. We will see this as we discuss fixed and variable costs.
To make things easier we should start with variable costs and where this distinction is usually drawn. The main point of distinction between fixed and variable costs is the absence or presence of a cost driver’s relationship. Variable expenses are those which are driven by a change in the activity levels. If you manufacture widgets, manufacturing more widgets will increase your raw material cost of widgets. So the variable is short for “vary directly with activity levels”. More activities, more variable costs. Less activity, less variable costs.
As you’ve gathered by now the fixed in fixed costs is not a matter of being immovable costs. Fixed costs are costs that do not have a direct relationship with the level of activity. Let us go back to our widget manufacturing business. When lockdown struck and we could not manufacture because we were deemed non-essential services the landlord still demanded rent for the factory as we had a lease in place. That is a fixed cost. To further demonstrate this when lockdown restrictions were relaxed we decided to work day and night to produce more widgets as the market was running dry of them. Our rent did not increase even though the activity level doubled as did our output of widgets.
Stepped Fixed Costs
Just to add a little bit of nuance, not all fixed costs are equally fixed. There are what we call stepped fixed costs. Going back to the widget business, we obviously need storage for our widgets after manufacture. Our landlord has storage rooms on the premises that we can rent out as and when we need them for a month. One storage room holds 1000 widgets at full capacity. Normally we produce 900 units and only use 1 room. But since lockdown restrictions were lifted we have doubled our production to 1800 units. To store these we require 2 rooms. This is a stepped fixed cost. It is fixed within a range of activity. So it is somewhat variable but not directly.
The distinction between fixed and variable costs involves product-related costs. Operating expenses do not come into the discussion. Operating expenses cannot be linked in any way to the process of creating or delivering products. For example, our widget business pays an Internet service provider. We use the Internet to communicate with our clients, suppliers and other people we need to talk to and also read articles on Startupbiz.co.zw. While the activities we use the Internet for are part of our business they cannot be linked with the production of the product. If however, we were a design business that used online-based software to produce work then that Internet cost would qualify as a fixed cost. So this distinction depends more on the nature of the business than on the expense.
As mentioned before this information is used in management decision making. So whether it’s just a cost-benefit analysis, break-even analysis or a make or buy decision that is where this distinction between costs is applied.