Fixed and variable costs, direct and indirect costs

Fixed and variable costs, direct and indirect costs. The differences

Whether we are setting up a new business or evaluating the results of the business that is in progress, it is important that we know how to analyze fixed and variable costs. It is also important to know the difference between costs and expenses, direct and indirect costs. The success of the business depends a lot on the planning, the control of expenses and the financial management that is done.

Estimated reading time: 9 minutes

What is the difference between fixed and variable costs?

Fixed cost is the cost that does not depend on increases or decreases in the volume of sales or production of the activity.

Variable cost, instead, varies, as the name implies, with variations that occur in production or sales.

So what are the fixed costs?

Fixed cost is what is maintained over time, regardless of whether sales or production increases or decreases.

For example, what we pay in space rent does not depend on what we are selling and producing, whether a little or a lot. The invoice payable always remains the same, therefore, fixed.

Fixed cost examples:

Text indicating ADVERTISING
  • Maintenance of equipment, property and structure;
  • Labor;
  • security and cleaning services;
  • Space rentals, vehicles;
  • Supplementary benefits of human resources, such as fuel vouchers, meal vouchers and other benefits;
  • Electricity, telephone and internet consumption;
  • Personal accident insurance, health insurance, etc.;
  • Costs with servers, computer equipment, platforms and software;
  • Among others.

These charges are essential for the operation of the company and, therefore, are also known as structural costs.

These are costs that should be under the managers' sights because, if proportionally to the variable costs these fixed costs are very high, it means that the structural costs are significant.

Therefore, it could be necessary to make them more flexible, converting them into variable costs or reducing their value, otherwise the business becomes unfeasible.

What are the variable costs of a company?

Unlike the fixed cost, the variable cost increases or decreases, according to the variation of production or the provision of services that the company provides.

Examples of variable cost are:

  • Electricity and water – if production depends on it;
  • Overtime paid to employees;
  • Salaries paid to employees who are temporarily hired to deal with production peaks;
  • Raw material used;
  • Costs inherent to logistics and delivery of goods;
  • sales commissions;
  • Among others.

There are also semi-variable costs, that is, they do not increase in proportion to the variable costs. They follow the volume of production, but with a different proportionality.

Text indicating ADVERTISING

These examples may not be suitable for every business. The electrical energy spent in an office is a fixed cost, but in an industrial company that requires energy to manufacture products, it is considered a variable cost.

How to calculate fixed and variable cost

In the restaurant that we have used as an example, we have outlined a sales plan  in which we will sell €143.493 in the cruise year.

The details of these income are presented in the following table:

Sales Plan example restaurant year cruise speed
Sales Plan example restaurant year cruise speed

Calculate the average selling price per unit

With the number of products and services to be sold per day and the number of days per year that each of these products will be sold, we can calculate the value to be sold at the end of the year:

  • 25 meals a day x 300 days = 7500 meals
  • 30 x 300 = 9000 drinks
  • 30 x 12= 360 special events
  • 20 x 300= 6000 pastries and breakfasts
  • 15 x 300 = 4500 desserts
  • 25 x 15 = 375 group dinners
  • 30 x 100 = 3000 Friday and Saturday dinners

That is, an annual total of 30.735 products or events what it means:

Average unit selling price = €143.493 / €30.735 = 4,67€

Calculate the average unit variable cost

The costs we calculate to produce these products are as follows:

Variable costs
Variable costs

The variable cost is therefore €30.225 and corresponds to 30.735 products produced, that is:

Average variable cost unit of the product = €30.225/30.735 = 0,983€

Se we sell each product on average by 4,67€ with a average variable cost of €0,983: average gross profit per unit is de 3,687€.

Multiplying this value by the total number of products 30.735 o annual gross profit will be 113.268€.

Since mathematics is a rigorous science, this is precisely the value we calculated when we did the calculations for the gross margin.

Gross Margin = €113.268 / €143.492 = 79%

How to calculate average unit fixed cost

Let's continue with the example of our restaurant and see what Supplies and external services tell us:

Supplies and external services
Supplies and external services

The costs considered here are part of the fixed costs of our business and have a value of €32.284.

Let's look at other of the costs that are normally fixed, the Labor costs.

Labor costs
Labor costs

Adding this cost to the previous one:

Fixed Costs = €32.284 + €44.179 = €76.463

Average unit fixed cost = €76.463 / €30.735 = €2,49

Finally,

Total costs = €76.463 (fixed cost) + €30.225 (variable cost) = €106.688

Total unit cost = €106.688 / €30.735 = €3,47

The importance of differentiating fixed and variable costs

Differentiating between fixed and variable costs is important in order to better plan the evolution of the business and to know the impact of sales and production volume on these costs.

With this analysis, we were able to verify the need to review prices and readjust each one of the costs if necessary, that is, if they should remain as variable or fixed and if there is a need for a strategy to reduce these expenses to improve profitability.

Impact on costs due to changes in sales and production

For example, if we want to make an assessment of what the average cost will be if, instead of selling 30.735 products a year, we sell 35.000?

The annual fixed cost will be the same €76.463, assuming that no more people will be needed and the variable cost will be the variable unit cost multiplied by the number of products.

€76.464 (fixed cost) + €35.000 x €0,983 (variable cost) = €76.464 + €34.405 = 110.284€ (total cost)

The new average unit fixed cost will then be = €76.463 / €35.000 = 2,18€

As the fixed cost does not vary with the increase of production, it means that the average unit fixed cost will decrease with the increase of production. It went from €2,49 to €2,18.

The unit variable cost is maintained because it varies according to the variation of manufactured or produced products

New Average unit total cost = €110.284 / €35.000 = €3,15

It went from an average total cost of €3,47 to €3,15.

That is why the statement is correct: the more you sell, the more you earn, that is, the greater the profit.

Higher sales imply higher production, which, with the same fixed costs, reduces the total unit cost and, for the same sales price, will increase profit.

With more sales and greater production, the company can have greater profitability or, by lowering the price, it can become more competitive.

It is clear that the increase in production may, from a certain value, make it impossible to maintain the same fixed costs, for example if this forces the necessary labor force to be adjusted.

In this example, the workforce needed to produce and sell 30.735 products is 4 people (1 manager and 3 more employees) and it is possible that they can produce a little more.

Within these limits, they are a fixed cost, because even if the production is lower, they will have to remain on the staff.

If there are production peaks, and if it is possible to have more manpower who, working temporarily during this period, can guarantee production.

In this case, the labor will be a variable cost because it can be adjusted up and down, according to the production volume.

This capacity can also be solved with the use of overtime as needed and, therefore, considered variable costs.

The economies of scale

The company must be able to calculate the optimal level of production, to obtain what is called economy of scale.

This will be the level that minimizes unit production costs.

Direct and indirect costs

Another classification used in analytical accounting is that of direct and indirect costs.

Direct costs are costs that can be affected or attributed to an activity, such as the cost of raw materials. Usually these costs are variable.

Indirect costs are costs that cannot be allocated specifically to an activity or service, such as manufacturing overheads. These costs are usually fixed.

Expenses and income, payments and receipts, costs and income, what are the differences

The company's revenues result from sales of products and services.

Revenue or income is the right to receive an amount for the transaction.

Expenses or costs are obligations to pay for a product or service received.

  • Costs and income, are from the economic area
  • Expenses and income, payments and receipts belong to the financial area.

In English, the receipt is a “cash in flow”, that is, it is money that enters the company.

Payment is a “cash out flow”, that is, a flow of money that leaves the company.

This is an important difference because when money comes in or goes out it is a treasury issue, therefore a financial issue.

A benefit is the right to receive, that is, the money has not yet entered the company. We have already sold and acquired the right to receive. Economically, we sell, but if the customer does not pay this profit, it is not effected and becomes a debt.

Costs are expenses that bring financial return because they belong to the company's activity.

An expense is an expense in an activity that does not generate a financial return, at least directly. It just brings a certain comfort or functionality to the business environment.

For example, an employee's award does not generate a return, but it can lead to greater commitment and satisfaction, which can bring greater productivity and new ideas, which can be important for the activity.

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