What is the difference between fixed and variable costs?

Fixed costs are consistent and do not change with the level of output, while variable costs fluctuate based on production volume.

Fixed costs are those expenses that a business incurs regardless of its level of output. These costs are constant and do not change with the volume of goods or services produced. Examples of fixed costs include rent, salaries, insurance, and depreciation. These costs are incurred even if the business does not produce or sell a single product. For instance, a business must pay rent for its premises whether it produces 100 units or 1,000 units.

On the other hand, variable costs are those that change in direct proportion to the level of output. These costs increase as production increases and decrease as production decreases. Examples of variable costs include raw materials, direct labour, and utilities like electricity and water that are used in the production process. For example, if a business produces more units, it will need more raw materials, and thus the cost of raw materials will increase.

Understanding the difference between fixed and variable costs is crucial for businesses as it impacts pricing decisions, budgeting, and profit calculations. It's also important for break-even analysis, which determines the volume of sales needed to cover all costs. In this analysis, fixed costs are spread over all units produced, reducing per unit cost as production increases. Variable costs, however, remain constant per unit regardless of the volume of production.

In summary, fixed costs are constant and do not change with the level of output, while variable costs change in direct proportion to the level of output. Both types of costs play a significant role in the financial management of a business.