Fixed and Variable Costs

All costs firms fall into one of two categories. They will be fixed costs which are costs that don’t vary with output. Or they will be variable costs which do vary with output.

If we took the example of a firm making dresses a fixed cost could be a dress factory. The cost of this factory is the same whether one dress or a thousand dresses are being made. (Of course the more dresses you make the lower the cost of the factory per dress.)

An example of variable costs for the dress making firm would be the material. As you produce more dresses you will have to buy more material with which to make them. The material costs vary with output.

The total costs for the firm will be the variable costs plus the fixed costs.

While both fixed and variable costs are very important and we will want to keep both to the minimum. The variable costs are the ones which are most vital to the daily survival of our company though.

Why is this? Well, imagine if the variable costs of each dress (the material and casual labour) was not even covered by the sale price. Each dress costs $1000 in materials but you only sell it for $900. In other words you are losing $100 per dress, just in the variable costs. In this situation you should production down.

By contrast if you were able to sell each dress for $1100 you are covering the variable costs of production but you are also making the $100 which can be used to contribute to the fixed costs.

To check you understand the difference between fixed and variable costs think of shop or business you are familiar with and jot down their key costs and then separate them out. Which ones vary with output and which ones are constant.

The following article is also quite useful for looking at how changing fixed and variable costs affect a firm.

(Note how routes where variable costs such as fuel and charges are being closed while other routes continue to be flown even though firm is making a loss overall due to high fixed costs.)


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