How to Calculate Fixed and Variable Costs: Examples and Explanations

Businesses have many costs they need to consider when trying to make a profit. One of the most important concepts to understand is the difference between fixed and variable costs. Don’t stress if you do not clearly understand the concept of the two and the difference between them. We are here to help you out with ease.

In this article will provide examples of each type of cost and explain how they can impact your business. Understanding these concepts allows you to make more informed decisions about your expenses and improve your business undertakings.

One powerful tool that can significantly aid in managing and calculating both fixed and variable costs is Deskera ERP. With its robust financial management capabilities, Deskera ERP enables businesses to track, categorize, and analyze their fixed and variable costs in real-time.

This integrated approach not only enhances accuracy but also provides valuable insights through detailed reporting and analytics, helping businesses make informed decisions to optimize their cost structures and improve overall financial performance.

So, if you're ready to learn more about fixed and variable costs, let's get started!

What is Fixed Cost?

Fixed costs are those expenses that remain constant regardless of how much or how little you produce. In other words, they're not directly affected by changes in production volume. Fixed costs include rent/mortgage, insurance, property taxes, interest on loans, depreciation, legal fees, and accounting fees.

One common misconception is that fixed costs always stay the same. While it's true that they don't fluctuate with production volume, they can still change over time. For example, your rent may stay the same for several years but then increase when your lease is up for renewal.

To better understand fixed costs, let's look at an example. Let's say you own a small bakery. Your monthly expenses include rent ($500), utilities ($200), flour ($100), sugar ($50), eggs ($20), and labor ($500). In this scenario, your rent, utilities, flour, sugar, and eggs would be considered variable costs because they fluctuate with production volume. For example, if you produce 100 cakes in a month, you'll need twice as much flour as you would if you only produced 50 cakes.

Labor is the only ongoing expense regardless of how many cakes you sell. Even if you only sell one cake a month, you still have to pay your employees for their time. This is what makes labor a fixed cost.

Now that we've covered the basics of fixed costs let's look at how they're calculated. To calculate your fixed costs, add up all your expenses that remain constant regardless of production volume. In our example above, the total amount of fixed costs would be $500 + $200 + $100 + $50 + $20 = $870.

What Is the Average Fixed Cost?

Now that we know what fixed costs are, let's talk about average fixed cost (AFC). Average fixed cost is your company's total fixed costs divided by the number of units you produce.

To calculate AFC, you would have to use the following formula:

AFC = TFC / Q

Where TFC is your total fixed costs and Q is your production quantity.

Let's say, for example, that it costs a company $100,000 to produce 100 widgets. The variable cost per widget is $0.50, and the total variable cost for producing all 100 widgets is $50,000. This leaves us with a total fixed cost of $50,000 ($100,000 - $50,000 = $50,000).

Now, we can plug those numbers into our AFC formula to calculate the average fixed cost per widget.

AFC = $50,000 / 100 widgets

AFC = $500 per widget

As you can see, the average fixed cost decreases as production increases. In other words, AFC gets cheaper as you produce more and more widgets. This is because your total fixed costs are spread out over a larger number of units when you produce more.

What is Breakeven Point?

The breakeven point is the number of units that must be sold to cover your costs. Your goal is to always sell above your breakeven point to make a profit. To calculate your breakeven point, you need to know two things: your fixed costs and your variable costs per unit.

To calculate your breakeven point, divide your total fixed costs by your selling price per unit minus your variable costs per unit. For example, let's say you have $200 in monthly fixed costs, and it costs you $50 in variable costs to make each widget you sell for $100 each. In this case, your equation would look like this:

$200/$100-$50 = 200/50 = 4

This means that you need to sell four widgets just to break even.

Once you know your breakeven point, you can start setting sales goals. Remember, your goal is always to sell above your breakeven point to make a profit. So if you want to make $500 in profit, you would need to sell five widgets at $100 each.

It's important to remember that your costs and selling prices will change over time. As a result, your breakeven point will also change. For this reason, it's a good idea to calculate your breakeven point regularly to adjust your sales goals accordingly.

How to Calculate Fixed Cost?

You have learned what fixed cost is. But that is not enough. You also need to understand how to calculate the fixed cost. There are two ways to figure out fixed costs. The first technique use the following easy formula:

Fixed cost = Total cost of production - (Variable cost per unit x number of units produced)

Add up all of the production expenses first. Take note of which of these costs are constant and which are changeable. Subtract the variable cost of each unit times the quantity you generated from your overall production costs. You are then given the entire fixed cost. The second method of figuring out fixed costs is adding up all your fixed expenses. The tally method's stages for calculating the fixed cost are as follows:

List All Costs

List every monthly expense your company has to start. You may create a list using budgets, receipts, and bank account transactions. To get the monthly expenditures, divide the yearly expenses by 12. Preferably on a spreadsheet, list all your expenses and their monthly cost.

For example, Mr.Hari Lal Ltd. manufactures doll toys for kids. The company must determine its fixed costs to determine a fair price for its goods. They create a list of all their monthly expenses.

Figure Out Fixed Costs and Keep Variable Costs Apart

Iterate the list of expenditures by ongoing costs (those that don't fluctuate depending on sales volume) and variable costs as you're only involved in the fixed costs (those impacted by sales or production).

For example, Mr.Hari Lal Ltd. divides its total list of expenses into fixed and variable costs. They pay $3,000 in facility rent, $80,000 in staff salaries, $2,000 for equipment, and $200 for a website as fixed expenditures.

Add Fixed Costs

The fixed cost list's separate monthly totals are added together. That figure represents your entire fixed monthly expense.

Example: To determine its overall fixed costs, Mr.Hari Lal Ltd. sums together all of its separate fixed expenses.

₹ 3,000 + ₹ 80,000 + ₹ 2,000 + ₹ 200 = ₹ 85,200

Now Mr. Hari Lal Ltd. knows that their dolls' cost must include Rs. 85,200 every month. Mr. Hari Lal Ltd. must compute the average fixed cost to establish the appropriate pricing per doll.

How Do You Calculate Fixed Costs Per Unit?

Divide the total fixed cost by the quantity of units sold to arrive at the fixed cost per unit. Let's take the example of Mr. Hari Lal Ltd., who has 6,000 dolls for sale. Divide the fixed cost of 85,200 by 6,000 to get the fixed cost per unit (the number of units for sale). The average fixed cost or fixed cost per unit is 14.20. Mr. Hari Lal Ltd. should add 14.20 to the sales revenue to account for the fixed cost.

Let's say Mr. Hari Lal Ltd. wants to boost his earnings. Increasing manufacturing and creating more dolls is one method to do this. Mr. Hari Lal Ltd. spends 14.20 in fixed costs per unit produced at the present rate of 6,000 dolls each month.

The business may increase manufacturing to 8,000 dolls each month. They now have a fixed cost per unit of 10.65. Without changing spending, the corporation may increase its profit per doll sold by an extra 3.55.

Examples of Fixed Cost

We have learned what fixed cost is and how it is a vital part of your business. We have also learned how you can calculate the fixed cost incurred to mention in your books. To understand it a little better here are a few examples of fixed cost.

The most common examples of fixed cost include:

1. Labour

It represents the compensation given to the personnel employed in the office and manufacturing. The business pays the majority of the labor force. Each month, they receive a fixed salary.

2. Website

Most businesses have a website to keep up their internet presence. They usually pay a set fee for website design, website hosting, and search engine optimization. Website owners are also investing in embedding Google Reviews on their websites to engage the audience.

3. Online stores

If your company has an online marketplace, you should prepare for a fixed expenditure due to e-commerce fees.

4. Loans

Many companies take out loans to launch their own firms. They frequently have to repay loans with a set monthly payment.

5. Licenses

Many companies must get permits or licenses to operate lawfully, and they sometimes have to pay a monthly fee to update those permits/licenses. For instance, establishments that sell alcohol need to apply for and renew their liquor license annually.

6. Maintenance

Numerous expenses are covered under maintenance, such as those cleaning supplies, mechanical repairs, or yearly tune-ups for automobiles. Most of the time, this expense is constant and occurs on a predetermined schedule.

7. Rent

The majority of firms make monthly rent payments. This cost is inevitable if the company does not own the premises. Due to the possibility of an increase in rent within a year, fixed costs are estimated for a little time.

What is Variable Cost?

In business, the term "variable costs" refers to those expenses that change concerning the amount of goods or services produced. Variable costs increase or decrease as production increases or decreases. Common examples of variable costs include raw materials, commissions, and direct labor. The total variable cost is the sum of all these individual variable expenses.

Variable costs are significant because they directly impact a company's profitability. For example, if a company produces 100 widgets at a total cost of $500, and the variable costs are $200, then the company's gross margin (total revenue minus total cost) would be $300. If the company could reduce its variable costs by just $20, its gross margin would increase to $320. And since the gross margin is the money that a company has available to pay its fixed costs and generate a profit, it's easy to see how reducing variable costs can significantly impact profitability.

There are a few different ways to reduce variable costs. One is negotiating better prices with suppliers for the raw materials needed to produce the product or service. Another is to increase productivity so that fewer labor hours are required to produce each unit. And finally, companies can sometimes automate part of their production process, leading to lower labor costs.

How to Calculate Variable Cost?

The variable cost per unit is the quantity of materials, labour hours, or other resources utilized to make the product. For instance, Mr. Hari Lal Ltd. charges Rs. 300 for each doll it sells, but it costs Rs. 200 to design, create, package, and promote each doll; therefore, the variable cost is Rs. 200.

The number of products that the firm produces is the total no. of units produced. For example, 200 dolls are produced each month by Mr. Hari Lal Ltd. As a result, the following formula is used to get the total variable cost:

Total variable cost = Cost per unit x Total number of units produced

For Example: Multiplying the price of each doll by the no. of dolls made each month would get the variable cost for Mr. Hari Lal Ltd. throughout the manufacture of 200 dolls.

Total variable cost for Mr. Hari Lal Ltd. = ₹ 200 x 200 = ₹ 40000

How Do Semi-Variable Costs Separate Fixed and Variable Costs?

Semi-fixed costs or mixed costs are other names for semi-variable expenses. Both fixed and variable components make up these kinds of costs. Up to a certain level in manufacturing, they are fixed; beyond that, they are changeable. Even in the absence of manufacturing, costs are fixed. It is simple to distinguish between the two since fixed costs are recurring, whereas variable costs fluctuate depending on manufacturing output and the general activity level.

Example of Variable Costs

After fixed cost it is time to see variable cot more clearly to help you understand what goes into your bookkeeping process and under what category. The raw materials needed to make each product, selling commissions for every sale, or shipping costs per unit are a few examples of variable costs. Here are a few instances of variable expenses.

1. Shipping

Shipping costs will increase as your sales increase since more things must be shipped to customers.

2. Utility bills

Your level of productivity may have an impact on some utility costs. For instance, your power cost would be significantly greater if you manufacture thousands of things than if you make five.

3. Raw materials

Each product you make and sell requires using raw materials. The quantity of raw resources needed to produce each product increases as sales volume increases.

4. Labor

You'll need to recruit additional labor to increase your production levels, even though employee salaries are largely consistent and may be a fixed cost. More workers would be required to produce more goods or deliver more services; hence, some labor might be considered a variable cost.

5. Sales commissions

If you provide your staff commissions, you'll have to deduct a little portion from each concluded deal.

6. Credit Card Fees

A firm is only subject to fees if it permits client credit card payments. The credit card fees, which represent a proportion of sales, should be regarded as a variable instead of a monthly fixed cost.

7. Freight Out

A company only pays for shipping whenever it sells and sends out a product. As a result, freight out is a variable expense.

Total Variable Cost vs. Average Variable Cost

While total variable cost reveals how much you spend on each unit of your product's development, you may also need to consider items with various variable costs per unit. The average variable cost enters the picture here.

For example, You have two separate variable costs, $60 and $30, if you have 10 units of Item A at a variable cost of $60 per unit and 15 units of item B at a variable cost of $30 per unit. These 2 variable expenses are combined into your average variable cost, a single, reasonable sum.

In the example above, you may calculate your average variable cost by combining the total variable costs for Items A and B ($60 x 10 units & $45 x 15 units, respectively) and scaling the amount by the units produced (10 + 15 or 25).

You have an average variable cost of $42 per unit, or ($600 + $450) x 25.

Variable Cost Ratio

Businesses may identify the exact correlation between variable expenses and net sales using the variable cost ratio. They can account for rising sales and manufacturing costs by calculating this ratio, which enables them to maintain consistent business growth. The formula is

Variable cost ratio = Variable Cost/Net Sales

Let's use it in real life. If a product costs $20 to develop but costs $200 to sell (Net Sales), you divide $20 by $200 to just get 0.1. Your variable cost ratio is 10% when multiplied by 100. This implies that you receive a 90% return on every product sold, with the remaining 10% covering variable expenditures.

In contrast, combining fixed and variable costs could help you determine your break-even point or the spot at which the cost of making and selling things equals zero.

Reconsider the example from before. If your fixed expenses are $100 and your variable costs are $20 for a $200 product, your total costs ultimately make up 60% of the sale price, leaving you approximately 40%.

Clearly define? Your potential profit decreases as your overall cost ratio rises. If this figure falls below the break-even mark, you will lose money on each transaction.

Difference Between Fixed Cost and Variable Cost (with Example)

Fixed costs and variable costs are two fundamental categories of expenses that businesses incur. Understanding the difference between these two types of costs is crucial for budgeting, financial planning, and pricing strategies.

Fixed Costs: Fixed costs are expenses that remain constant regardless of the level of production or sales volume. These costs do not fluctuate with business activity and are incurred even if a company produces nothing.

• Example: Rent for office space is a fixed cost. Whether a company manufactures 100 units or 10,000 units, the rent remains the same each month. Other examples of fixed costs include salaries of permanent staff, insurance premiums, and depreciation of equipment.

Variable Costs: Variable costs, on the other hand, are expenses that vary directly with the level of production or sales volume. These costs increase as production increases and decrease as production decreases.

• Example: The cost of raw materials is a variable cost. If a company produces more units, it will need more raw materials, thereby increasing the cost. Conversely, if production is reduced, the cost of raw materials will decrease. Other examples of variable costs include direct labor costs (wages paid to hourly workers), utilities used in the production process, and shipping costs.

Comparison:

• Nature of Costs: Fixed costs are constant and do not change with production levels, while variable costs fluctuate with production volume.
• Impact on Total Costs: Fixed costs contribute to the overall expense regardless of output, leading to higher per-unit costs when production is low. Variable costs, however, change proportionately with output, leading to more predictable per-unit costs.
• Examples: Fixed costs include rent, salaries, and insurance. Variable costs include raw materials, direct labor, and production supplies.

Understanding the distinction between fixed and variable costs helps businesses in pricing products, budgeting, and financial planning. For example, knowing the fixed costs allows a company to determine its break-even point - the level of sales at which total revenues equal total costs. Managing variable costs efficiently can help in optimizing production processes and improving profitability.

Variable Costs vs. Fixed Costs in Decision-Making

Enterprises bear both fixed and variable costs. Variable costs fluctuate as output levels change, as was previously noted. Contrarily, fixed costs are expenses that are consistent independent of the amount of production (like office rent). Making business decisions requires an understanding among which costs are fixed and which costs are variable.

For example, Suzi is quite worried about her cafe since the sales revenue is less than the overall cost of operating the cafe. Suzi demands to learn your thoughts on whether she ought to shut down the company. In addition, she has already agreed to cover the cost of a year's worth of rent, energy, and employee wages.

Suzi would therefore continue to pay these expenses through the end of the year even if the company closed. The company recorded $3,000 in sales for January, but $4,000 in total expenses, with a net loss of $1,000. Suzi predicts that February's earnings trends will be similar to January's. The following is Suzi's estimate of expenses for the cafe:

A. January fixed costs:

Electricity: $200

Rent: $1,000

Employee salaries: $500

Total January fixed costs: $1,700

B. January variable expenses:

Total cost of labor: $500

Cost of eatables and drinks: $1,800

Total January variable costs: $2,300

Suzi would have difficulty choosing wisely if she didn't know which expenditures were variable or fixed. In this scenario, we can observe that there are $1,700 in total fixed costs and $2,300 in total variable costs.

Suzi would still be obligated to pay $1,700 fixed charges each month even if she closed the company. Suzi would only experience a $1,000 monthly loss if she carried on with her business ($3,000 in sales minus $4,000 in total expenditures). Suzi could lose a lot of money ($1,700 per month) when she decided to stop running the company.

This illustration shows how expenses factor into decision-making. The best action in this situation would be for Suzi to carry on with her company while searching for methods to cut the variable costs associated with her output (e.g., see if she could save raw materials at a low price).

Calculation of Variable Cost

Say that a cupcake costs a bakery $15 to make: $10 in direct labour expenses and $5 in cost of raw materials (including wheat, milk, and sugar). The following table demonstrates how the variable expenses vary depending on how many cupcakes are made.

Variable expenses at the bakery rise together with the output of cupcakes produced. The bakery's variable costs disappear when no cakes are baked.

The total cost is made up of both fixed and variable charges. Total cost influences a company's earnings, which are determined as follows:

Profits=Sales−Total Costs

By lowering its overall expenses, a business can boost profits. Since reducing fixed costs is more complex (for instance, lowering rent would require the company to relocate to a less expensive area), most businesses focus on lowering their variable costs. Costs are typically reduced by lowering variable costs.

The bakery's gross profit per cupcake will be $35 - $15 = $20 if each cupcake is sold for $35. The fixed expenses must be deducted from the gross profit to get the net profit. The bakery's monthly profit will seem like this if its fixed monthly expenses are $900, which covers utilities, rent, & insurance:

A firm will lose money if fixed expenses are more than gross profits. In the bakery's scenario, with just 20 cakes sold each month, gross revenues are $700 - $300 = $400. This would miss $500 in sales since its fixed cost of $900 is more than $400. The break-even point is reached when fixed expenses and gross margin are equal, and there are no gains or losses. In this instance, the bakery achieves financial balance by selling 45 cupcakes for a value of $675 in variable expenses.

A corporation may need to reduce fluctuating prices for raw materials, direct labour, and advertising if it wants to boost profits by lowering variable expenses. The quality of the products or service shouldn't be compromised throughout the cost-cutting process, though, since this would hurt sales. A company can raise its gross profit margin by lowering its variable expenses.

The contribution margin enables management to calculate the potential profit and revenue from every sold unit of a product. The contribution margin is determined as follows:

Contribution Margin= Gross Profit/Sales= (Sales-VC)/Sales

The bakery's contribution margin is ($35 - $15) / $35, which is 0.5714, or 57.14 percent. The bakery's marginal revenue will rise to ($35 - $10) / ($35) = 71.43 percent if its variable expenses are reduced to $10. Whenever the contribution margin rises, profits rise as well. The bakery would make $0.71 per dollar in sales if it could cut its variable costs by $5.

How Can Deskera Help You?

Deskera ERP can assist with managing fixed and variable costs in several ways:

1.Cost Tracking and Allocation:

• Fixed Costs: Deskera ERP can track recurring fixed costs such as rent, salaries, insurance, and depreciation. The system allows you to categorize and allocate these costs accurately across different departments or projects.
• Variable Costs: It helps in recording and analyzing variable costs like raw materials, production supplies, and utilities. By tracking these costs in real time, businesses can better understand cost fluctuations and their impact on overall expenses.

2.Budgeting and Forecasting: Deskera ERP provides tools for budgeting and forecasting, enabling businesses to plan for both fixed and variable costs. By comparing actual costs against budgets, businesses can identify variances and make informed decisions to control expenses.

3.Expense Management: The ERP system streamlines expense management by automating the recording and approval of expenses. This helps in maintaining accurate records and controlling both fixed and variable expenses effectively.

4.Cost Analysis and Reporting: Deskera ERP offers detailed reports and analytics that provide insights into cost structures. Businesses can analyze trends, identify cost-saving opportunities, and optimize both fixed and variable costs.

5.Inventory Management: For variable costs related to inventory, Deskera ERP provides comprehensive inventory management features. It helps in optimizing inventory levels, reducing carrying costs, and minimizing stockouts or overstock situations.

6.Supplier and Purchase Order Management: Managing relationships with suppliers and handling purchase orders efficiently can help control variable costs. Deskera ERP facilitates better supplier negotiations and ensures timely procurement, reducing costs and improving cash flow.

7.Automation and Efficiency: By automating routine tasks and workflows, Deskera ERP reduces the need for manual intervention, which can lower labor costs (a part of fixed costs) and increase overall efficiency.

8.Real-time Data and Insights: Real-time data availability allows for prompt decision-making. Businesses can quickly react to changes in variable costs and take proactive measures to manage fixed costs.

By leveraging these features, businesses can gain better control over their cost structures, improve financial planning, and enhance overall profitability.

Key Takeaways

• Businesses incur both fixed expenses and variable costs.
• Over a given time frame, fixed expenses are constant. However, in the longer term, the fixed cost can change.
• Depending on the company's output, variable costs may go up or down.
• Rental fees, taxes, and insurance are some instances of fixed expenses.
• Direct labor, commission, & credit card fees are a few examples of variable expenses.
• You can find your company's break-even point by dividing total fixed costs by the difference between the selling price per unit and the variable cost per unit.
• You may determine which business knobs you have to pull by regularly analyzing your actual costs.
• Deskera ERP provides a holistic view of financial data, making it easier to manage and optimize both fixed and variable costs effectively.

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