◄Previous: 1 Cost classification

# 1.1 Variable and fixed costs

The distinction between variable and fixed costs is the basis of marginal costing. Once the variable and fixed costs are known for marginal costing, we can work out the marginal cost of a unit of output at any level of activity within the so-called relevant cost range. When we cannot accurately predict the future level of activity (which happens often), this classification of costs gives us a powerful management tool for evaluating results under different levels of activity.

Variable costs are directly proportional to the level of activity or output. Total variable costs are costs that change as the quantity of the good or service that a business produces changes.

For example, if activity doubles, the total variable cost also doubles; if activity trebles, the variable cost trebles. This assumes that, at unit level over a set range, the unit variable cost does not change.

In the case of a car factory, variable costs include raw materials, labour costs and direct production expenses – such as the engine, tyres, plastics and so on. Importantly, some indirect costs are also variable – for example electric power to drive the machinery and consumable materials such as lubricants. Variable costs are sometimes referred to as the marginal costs.

An important concept in connection with variable costs is contribution, which is an abbreviation of the phrase ‘contribution towards fixed costs’. It refers to the difference between the cost of sales that varies with production volume and the revenue generated – i.e. sales minus variable cost. Essentially, it is a measure of how much each unit of production or sales contributes to covering the fixed costs of a business. Contribution can be calculated per unit or aggregated for all production, providing valuable information for decision making and cost control.

Fixed costs are costs that remain constant, regardless of the level of activity or output.

Fixed costs are any other costs that are not variable. They are, in essence, a function of time, not of activity level or volume of output. They are the costs that would be incurred even if activity is zero. In a car factory, fixed costs include the rent, depreciation of equipment, management salaries, property taxes and so on.

In summary, total variable costs vary with changes in activity level, while fixed costs remain constant. Understanding the distinction between these two types of costs helps businesses make informed decisions about their production and cost management strategies. However, it is important to note that this holds true within a specific range called the ‘relevant range’. Fixed costs remain fixed within this range of output, beyond which they change. Similarly, variable costs per unit remain constant within the relevant range, after which they change (for example due to economies of scale, quantity discounts etc).

You will now consider these ideas in an activity.

## Activity 1 Cost classifications

Allow around 10 minutes for this activity

In an accounting practice, which of the following costs are variable and which are fixed?

Select the correct answer in each instance.

(a) an annual software licence fee for use of accounting software throughout the practice

fixed cost
variable cost

### Answer

(a) A software licence of this type is a fixed cost. It will only change if the level of activity shifts outside the relevant range. For example, if the licence fee covers five computers, it would only change if the practice grew and needed more.

(b) advertising

fixed cost
variable cost

### Answer

(b) Advertising is usually regarded as fixed, but you must consider the circumstances. Do we need to say what the circumstances are? This is because advertising expenditure usually arises ‘upfront’ as a result of a management decision, rather than being determined in a ‘cause and effect’ manner by units produced or sold.

(c) telephone bills

fixed cost
variable cost

### Answer

(c) Most telephone bills can be divided into a fixed rental component and a variable usage element. The rental is clearly fixed and, if the usage is related to activity in an accounting practice, the usage is variable. Where calls cannot be traced to individual clients, they are normally treated as costs of the period – that is, they would be treated in the same way as fixed costs are treated.

(d) secretaries’ salaries

fixed cost
variable cost

### Answer

(d) Secretaries’ salaries are a fixed cost.

(e) wages paid to the office cleaners

fixed cost
variable cost

### Answer

(e) The wages paid for office cleaning are normally treated as fixed unless there is a direct link between activity in the accounting practice and cleaning the office.

(f) 10% commission paid on sales

fixed cost
variable cost

### Answer

(f) Commission paid on sales is generally classified as a variable cost since it directly depends on the number of sales made by the company. As commission is typically calculated as a percentage of the sales revenue, it varies proportionately with the level of sales activity. When more sales are generated, the commission expense increases accordingly. Therefore, commission paid on sales is considered a variable cost as it fluctuates in relation to the company's sales performance.

◄Contents►Next: 1.2 Other ways of classifying costs

OpenLearn - Fundamentals of cost accounting and environmental management accounting
Except for third party materials and otherwise, this content is made available under a Creative Commons Attribution-NonCommercial-ShareAlike 4.0 Licence, full copyright detail can be found in the acknowledgements section. Please see full copyright statement for details.