In accounting, costs are considered fixed or variable, with all businesses using a combination of both. Manufacturing businesses use variable costs more frequently, since materials cost is directly tied to current manufacturing levels.
There are advantages and disadvantages to both categories, with fixed costs much easier to budget for, while variable costs are typically easier to lower than fixed costs.
In this guide, we’ll introduce you to both fixed costs and variable costs and how they impact your business. Both fixed and variable costs appear in your general ledger as well as on your balance sheet and income statement and both play a significant role when calculating financial projections for your business.
For manufacturing businesses, the accounting process becomes more complicated, with calculations such as fixed cost formula and variable cost formula often used to help determine profitability levels of the products currently being manufactured.
You’ll also want to look at total variable cost as well, since all of these factors combined will enable you to determine your contribution margin, which is essentially the cost of producing the product minus all variable costs.
Overview: What are fixed costs in accounting?
Fixed costs in accounting are costs that remain the same, and are not impacted by production levels. For instance, Tom owns a small manufacturing company that makes parts for small jets. He rents a small plant for $5,000 per month and currently has 10 employees: three who are salaried, and seven who are paid hourly.
Tom’s fixed costs are the rent that he pays each month, the insurance on the building, and his three salaried employees. Those are all fixed costs because the cost does not change from month to month.
Tom’s rent will always be $5,000 a month, his insurance will remain the same, and his salaried employees will be paid the same amount of money each pay period whether the factory manufactures 100,000 airplane parts or 10,000.
Fixed cost examples
- Property Tax
- Utilities (can be both fixed or variable)
While property tax and rent can fluctuate from year to year, they tend to remain the same for at least a year. Salaries include only those paid on a salaried basis and do not include hourly employees whose hours may change due to production demand. Temporary employees are also not included in salaries.
That same principle is also applied to utilities, which can be considered a fixed cost in many cases. As an example, the electricity cost for your business will likely remain consistent if you run a service business.
However, if your business includes manufacturing, the electricity can be considered a variable cost, as it will likely fluctuate with production. For instance, if you’re manufacturing products around the clock in order to meet increased demand, the cost of electricity will increase, making it a variable cost, not a fixed cost.
Overview: What are variable costs in accounting?
In most cases, variable costs are all related to production levels. Let’s go back to Tom’s manufacturing company.
While things like rent and Tom’s salaried employees are considered fixed costs, his hourly employees, any temporary employees he may bring in due to increased production, the cost of the additional materials needed to manufacture the parts that his business sells, and any commissions and shipping costs, would all be considered variable costs.
Variable cost examples
- Direct materials
- Production supplies
Going back to Tom again, during a busy month, he ships twice as many airplane parts as he did the previous month. In addition, he added two additional temporary employees to help process and ship orders.
Because of the increased sales, he also had to pay his salespeople a larger commission than he did the previous month. These costs are all varied and will likely continue to be so.
Fixed costs vs. variable costs: What’s the difference?
Fixed costs remain the same from month to month while variable costs are always tied to production levels and can vary based on current production. For instance, if you have a five-year lease on the building that your business occupies, the cost (the rent) will not change until the current lease expires.
However, if your sales orders rose in the last month, you’re paying for more materials to fill those orders, additional commissions to salespeople and increased shipping costs when sending out the orders.
When should you use fixed costs vs. variable costs?
Both fixed and variable costs will be used throughout the life cycle of your business. Even when preparing next year’s budget or calculating current operating expenses, you’ll want to review both cost types in order to ensure accuracy.
While the decision to use fixed costs or variable costs is fairly straightforward, there are times when it can be difficult to differentiate which category should be used. Here are a few examples:
When hiring a new employee
Your cost will be fixed or variable depending on how you’re paying the new employee. If you’re hiring an administrative employee, the expense will be fixed, while if you’re hiring an hourly employee, the cost will be variable, depending on the number of hours worked and any overtime that needs to be paid.
When calculating sales commissions
Sales commissions are always tied to production or sales and are always a variable cost. While you may need to estimate possible sales for the coming year, sales commissions will always vary with production.
When renting space
Rent payments are always fixed and will not change unless a new lease is signed.
When purchasing raw materials
Raw material costs will always be tied to production. Materials costs will drop when production drops, and pick back up as production does.
When shipping products
This can go either way, depending on what you’re shipping. Service companies that send out monthly ads to their customers may consider their shipping costs to be fixed, while manufacturing companies will always consider shipping or freight costs to be variable, and tied to production.
When calculating utilities
Even though utilities can vary, the amount they vary is fairly minimal. However, if you run a production plant and find yourself needing to run machines 24/7, the cost of the additional electricity will be considered variable, because it’s directly tied to production levels.
Why is it important for small businesses to understand their fixed and variable costs?
Whether you’re reviewing your company’s net income or trying to calculate a quick ratio, fixed and variable costs have a significant role in managing your business.
It’s impossible to determine accurate business income or determine if your business has enough assets to pay current liabilities without knowing what your fixed and variable costs actually are.
Final thoughts on fixed and variable costs
Useful in both financial and managerial accounting, fixed and variable costs impact your financial statements. There’s no way to calculate pretax income for your business or even determine cash flow without accounting for these costs.
If you’re struggling to keep track of fixed and variable costs manually, be sure to check out these top accounting software applications in The Blueprint’s accounting software reviews.
View more information: https://www.fool.com/the-blueprint/fixed-cost-vs-variable-cost/