Costs and its types – Fixed, Variable, Marginal and Total
What are costs?
The amount of money spent by a firm on the production or manufacturing of goods or services is called cost.
If a business sells its items at Cost price, it will not make any profits. As a result, merchants markup cost pricing to add a profit margin.
Based on the nature of the costs and their relationship with the output, costs can be classified into 4 types –
- Fixed Cost
- Variable Cost
- Total Cost
- Marginal Cost
Fixed cost (FC)
FC is a type of cost that does not change throughout a specific period. The rent of land is an example of a fixed cost that a small business owner gives to the landlord. If the owner charges 10,000 square feet of land at INR 500 a square foot for ten years, the rent equals INR 5,00,000 per month for those ten years, regardless of the profits made or losses incurred.
It is crucial to consider that fixed costs are not constant in the long run. Regarding our example, the rent would stay the same only until the following conditions remain consistent –
- The business owner continues to occupy the space.
- The landlord does not increase the rent at the end of the agreement of lease.
However, both of these conditions are most likely to change during the course of the business.
In a graphical presentation, the fixed cost curve is a straight line parallel to the x-axis (output) since fixed costs do not change with a change in output. Refer to the diagram below for more clarity.
Variable cost (VC)
VC, as the name suggests, are such costs that consistently vary over the life of the business. They are directly proportional to the output. When the output = 0, the variable cost is also equal to zero. Total Variable Cost (TVC) is the product of the total quantity of output and variable cost per unit of output.
An example of variable costs is operational expenses that can increase or decrease based on any business activity. A business may need more variable costs, including wages of staff hired, electricity, gas or water as levels of output increase. Variable expenses can be minimised, unlike fixed costs, to leave room for profits.
Knowing and managing variable costs is crucial for a company’s growth while adapting to the changes of a marketplace.
In a graphical presentation, the VC curve is an upward sloping line as costs keep increasing with a rise in the level of output. Refer to the diagram below for more clarity.
Distinguish between fixed cost and variable cost
Difference between Fixed and Variable Cost –
| Basis | Fixed Costs | Variable Costs |
| Meaning | Costs that remain constant for some time, regardless of the level of outputs. | Costs that vary in direct proportion to the changes in business activities. |
| Dependence | Dependent on fixed factors. | Dependent on variable factors. |
| Cost at Output = 0 | FC = n,
‘n’ is the fixed amount that stays constant. |
VC = 0 |
| Longevity | Found only in the long run. | Found in the long and short run. |
| Other names | Overhead costs, Supplementary costs or Period costs. | Direct costs, Prime costs. |
| Examples | Rent, loan payments, property taxes, depreciation. | Costs of goods sold, wages, commissions. |
Applications of Variable and Fixed Costs
Classifying costs as variable or fixed is important for companies. By doing so, companies can make a budget and analyse how they can reduce their costs. It is integral to analyse all costs so companies can make improved, stable and profitable business decisions.
For instance, if a corporation incurs high direct labour costs in manufacturing their products, they’ll look to invest in machinery to automate operations, reducing these high variable costs in exchange for stable fixed costs. Such decisions require considerations of volume capacity and volatility as trade-offs occur at different outputs. High volumes with low volatility favour machine investment, while low volumes and high volatility favour the utilisation of variable labour costs.
If sales were low, labour costs per unit would remain high. It may be wiser to not invest in machinery and incur a high fixed charge because the high unit labour costs would remain less than the overall fixed cost of the machinery.
Therefore, the optimum point of production is where profits get maximised, and costs are minimal.
Total cost (TC)
TC is the sum of fixed and variable costs.
A solid understanding of a company’s fixed, variable and total costs allows a business to form a profitable price index for its products or services.
Marginal cost
The marginal cost is the incremental cost of producing each additional unit of production. For example, a coffee shop makes 100 cups of coffee every day. The cost of each cup of coffee is INR 20. If the coffee shop increases its production to 101 cups of coffee, the one additional cup of coffee may cost INR 25. Therefore, the INR 25 is the marginal cost in this case.
The term “marginal cost” takes into account both fixed and variable costs. FCs are only calculated in marginal costs if they are necessary to expand output. VCs, on the other hand, are always included in marginal cost.
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