Fixed Cost vs. Variable Cost
All businesses have expenses, and those expenses can be broken down into one of two types, fixed or variable. Fixed expenses are those that do not change with business output, such as rents, property taxes and insurance. Variable expenses do change with business output, such as the cost of materials and labor.
Fixed costs do not change, no matter the amount of sales a company has. Whether the company has high or low sales, costs such as depreciation and rents remain constant. If a company has increasing sales, rents will remain the same. Conversely, if a company has decreasing sales, rents will still remain the same. Fixed costs are often referred to as overhead.
Variable costs do change with a company's sales. Such variable costs include the costs of materials or salaries. If a company has increasing sales, it will require additional materials and personnel. If a company has decreasing sales, it will require less materials and a smaller labor force. Variable costs fluctuate in direct proportion to the quantity of production.
Certain costs can also be considered mixed costs, which are costs that can be both fixed and variable. For example, electricity costs will increase as a company's production increases. However, if a company's production decreases, the cost of electricity remains fixed, as it is required to keep the business operational.
Businesses with high fixed costs are often able to discourage new competition, as the cost of entry is high. Examples of these types of businesses are airlines, car companies, and oil exploration. Businesses with high variable costs often have less barriers to entry, since costs are originally lower at inception. Examples of businesses with high variable costs are often in the service industry, as they weigh heavily on labor costs, and not expensive fixed costs such as equipment and other physical assets.
Total cost is the sum of both fixed and variable costs.
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