What is the difference between fixed and variable costs?

What is the difference between fixed and variable costs

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In the accelerating and changing world of business, companies face complex financial challenges that require precise strategies and a deep understanding of the factors affecting profitability. Among these factors, fixed and variable costs stand out as one of the basic pillars on which the success of any project depends. But how can a company distinguish between fixed costs that remain stable regardless of the volume of production and variable costs that are directly affected by production activity? What are the optimal strategies for managing these costs to achieve maximum efficiency and profitability? In this article, we will dive deep into this vital topic, revealing the best ways to deal with these costs and their critical importance in financial planning and strategic decision-making. So join us on this journey to explore the financial side of businesses, where the numbers meet, and the decisions that create success.

What are fixed and variable costs?

In the business world, there are two main types of costs:

Definition of fixed costs

It represents a type of expenditure that remains stable regardless of the volume of production or the company’s activity, as it is not affected by an increase or decrease in the volume of production. This makes it an essential and fixed part of monthly or annual expenses and includes a variety of expenses that are vital to the continuity of the business but do not change with a change in the level of production.

Example

Rent is one of the most important types of fixed costs, as the company remains obligated to pay it whether it produces a thousand units or one hundred thousand units of its products. Likewise, a property tax is imposed on the real estate owned by the company and does not change with the level of commercial activity.

Property and equipment insurance is also a fixed cost, as the company pays insurance premiums regularly to protect its assets, regardless of the size of its operations. Depreciation is also part of fixed costs, and it relates to the decline in the value of fixed assets, such as buildings and equipment, over time and is distributed over long periods to reduce its financial impact on the company.

These costs are not directly related to the company’s daily business operations but are still necessary to ensure business continuity and asset safety.

What is the concept of variable costs?

They represent an essential part of any business’s cost structure, as their value changes based on the amount of production and sales. This means that it grows as the volume of production increases and decreases as it decreases, making it directly affected by business performance and sales.

Example

Among the common examples of variable costs are labor costs, as the number of workers required increases as production increases and decreases as it decreases, leading to a change in expenses related to wages and social benefits. Variable costs also include utility prices, such as electricity and water, as these costs change based on the volume of consumption.

In addition, variable costs include raw material costs, as these costs increase as production increases because the required quantities of raw materials also increase. The costs of commissions and bonuses also change based on the volume of sales, as they increase as sales increase and decrease as sales decrease.

Explain fixed costs.

Fixed costs are those expenses that a company incurs on an ongoing basis, regardless of the level of production or sales, and they do not change with changes in the company’s operational size. Even if the company stops producing or selling completely, it will still be forced to pay these fixed costs, and this is what distinguishes them from variable costs, which rise and fall with a change in the level of operational activity. Remember that understanding the nature of these costs helps companies in financial planning and make better strategic decisions.

The difference between fixed and variable costs

Understanding the difference between fixed and variable costs helps in making more accurate and effective pricing and production decisions. The schedule of fixed and variable costs can be known through the following:

The differences Fixed costs Variable costs
Cost correlation It is time-related, meaning it does not change with the level of production. It is related to volume, meaning it changes with the level of production.
existence It exists even in the absence of production. It only arises when production is carried out.
The nature of the change It does not change as production changes. It changes directly with production.
Unit cost It changes as production changes. remain constant
Inclusion in stock It is not included in the cost of inventory. Included in the inventory cost

 

Why are the differences between fixed and variable costs important?

There are several main reasons why understanding the differences between fixed and variable costs is important for a business, which can be summarized as follows:

Determine the appropriate price.

When production costs are well understood, including fixed and variable costs, a company can determine the appropriate selling price for its goods and services, which helps ensure the company’s profitability and competitiveness in the market.

Economies of scale

Fixed costs do not change as production increases, while variable costs rise. Therefore, when a company increases its production volume, it benefits from economies of scale as fixed costs are distributed over a larger number of units produced, which leads to a decrease in the average cost per unit.

Break-even point analysis

Companies use break-even point analysis to determine the volume they must produce to cover all of their fixed and variable costs and begin making a profit. Fixed costs and variable costs are used in this analysis to determine the break-even point.

Make strategic decisions.

Understanding fixed costs and variable costs helps companies make strategic decisions, such as decisions to expand, invest, or close a particular product line.

Operating leverage

Operating leverage measures the extent to which a company can increase its operating income by increasing revenues. Companies that have low variable costs and high gross margins usually have higher operating leverage. This means that they can achieve more profits while increasing sales.

In contrast, companies with high fixed costs and low variable costs may face challenges in achieving profits while increasing sales.

Impact on financial statements

The distinction between fixed and variable costs is of great importance when preparing a company’s financial statements, as cash flows or pre-tax income cannot be accurately calculated without understanding these costs. In addition, these costs affect the analysis of the company’s profitability and operational efficiency, so financial managers must review this data regularly to ensure that the best financial decisions are being made.

financial planning

From the perspective of a business owner or company owner, understanding fixed and variable costs is crucial to preparing long-term financial plans, and thus this information helps in determining the break-even point, assessing operational risks, and developing appropriate pricing strategies. By carefully monitoring these costs, organizations can make informed decisions about investments, growth, and expansion.

Which of the following is an example of fixed costs?

Suppose that Gulf Electronics Company manufactures computers. Looking at operating costs, we find that there are fixed and variable costs:

Fixed costs

  • Factory rent: 50,000 Saudi riyals per month.
  • Administrative staff salaries: 100,000 Saudi riyals per month.
  • Maintenance and insurance costs: 20,000 Saudi riyals per month.
  • Total monthly fixed costs: 50,000 + 100,000 + 20,000 = 170,000 Saudi riyals.

These fixed costs do not change based on the volume of production. Even if the company does not produce any computers in a given month, it will still be obligated to pay these fixed costs of 170,000 Saudi riyals.

Variable costs

The variable costs are:

Raw material cost: ranging from 100 to 300 Saudi riyals per piece, depending on the volume of production.

Direct labor costs range from 50 to 100 Saudi riyals per computer.

Examples of variable costs

Suppose that Al-Masah Company produces pencils and sells them at a price of 2 Saudi riyals per pencil. The company bears a variable cost of 1 Saudi riyal for each pencil produced. If the company produces 5,000 pencils, the total variable costs will be: 5,000 pencils x 1 Saudi riyal per pen = 5,000 Saudi riyals.

But if production increases to 10,000 pencils, the total variable costs will be: 10,000 pencils x 1 SAR/pen = 10,000 SAR. In contrast, if the company does not produce any pencils at all, it will not incur any variable costs.

Notice

From this example, we see that variable costs change directly with the volume of production. The higher the production, the higher the variable costs, and the lower the production, the lower these costs, and thus this directly affects the company’s profitability and production decisions.

How can variable costs be reduced?

By focusing on the following strategies, the company can achieve significant savings in variable costs without sacrificing quality or productivity and will thus enhance its profitability in the long term:

increase production

By using the same number of materials, the company can increase the production rate and achieve savings in variable costs per unit produced. It is worth noting that this approach is based on achieving economies of scale, but it must be ensured that the increase in production does not negatively affect the quality of the final product.

Modernization of production processes

Investing in new technology and improved equipment may help reduce variable costs in the long term, and it is worth noting that these improvements can include different production procedures that lead to a reduction in labor or materials used.

Improving operational efficiency

Look for ways to reduce variable expenses, such as labor and utilities. This may include reconsidering the work structure or introducing more efficient practices.

How to add costs in the Qoyod accounting tree

If you want to add fixed and variable costs to the chart of accounts in the Qoyod accounting program, all you have to do is follow the following steps:

  • After logging in to the account, you will find in the side menu the “Accounting” field. After clicking on it, several options will appear, including “chart of accounts.”
  • After clicking on “Chart of Accounts,” a detailed page will open for all the tasks related to the Chart of Accounts, within which you will be able to create different sub-accounts.

 

  • On the page, you will find a different list of types of accounts for fixed and variable costs, depending on their types. You can select the account you want and press the + sign in the box corresponding to the account to create a sub-account. All you have to do is fill out the required fields, as shown in the image below:
  • With these steps and after filling in the necessary information, you will have added fixed and variable costs of all types to your chart of accounts.

Conclusion

Fixed and variable costs are an integral part of financial management strategies in any organization, and it is worth noting that understanding these costs and how to manage them effectively can have a significant impact on the financial performance and competitiveness of the company. By clearly identifying fixed costs and variable costs, companies can make more informed financial decisions, improve resource allocation, and also increase operational efficiency. So investing in understanding and managing these costs is not just a step towards improving profitability; it is a key to achieving long-term sustainability and growth. Remember that success in today’s business world requires more than just the ability to produce. It requires deep financial vision and the ability to adapt to economic changes effectively.

Are you looking for an effective way to manage your company’s costs with confidence and accuracy? Therefore, Qoyod accounting software is the ideal solution. By using it, you can track fixed costs and variable costs with ease and clarity. It also gives you a comprehensive view of your financial situation, which helps you make strategic decisions based on accurate data. It is worth noting that it also offers all its clients: the electronic invoice, as well as the point-of-sale system, customers, warehouses, and so on, which makes it the best accounting program.

After you know what fixed and variable costs are and the difference between them, try Qoyod now for free for 14 days, and remember that it is a reputable accounting program that guarantees your success and the sustainability of your business.

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