What it means
The simplest classification has three groups: fixed costs, such as rent and insurance, which stay the same in total within a normal range of activity; variable costs, such as materials and sales commission, which rise in direct proportion to volume; and mixed costs, which contain both elements. A phone contract with a base fee plus usage charges is a typical mixed cost.
A further group are step costs, which stay flat for a while and then jump. A warehouse might need one supervisor for up to 10,000 orders a month and a second supervisor beyond that level.
Costs like these look fixed in the short term and variable over the long term. The range of activity matters.
Behaviour is usually measured within a relevant range, the band of output the business normally operates in. Outside that range, fixed costs can change, such as when a new factory must be rented to expand beyond capacity.
Understanding behaviour matters because it affects how profit responds to sales. A business with mostly fixed costs sees profit swing sharply when sales change, while one with mostly variable costs sees steadier results.
This is the idea behind operating leverage. Another key effect is on unit costs.
Fixed costs are spread over more units as output increases, so the cost per unit falls even when the variable cost per unit stays constant. This is why a business can appear to be getting cheaper to run when it is simply getting busier.
To separate mixed costs, analysts can use historical data and compare high and low activity months, or run a regression. The outcome is an estimate of the fixed part and the variable rate, which is then used in budgets and forecasts, and which should be reviewed whenever prices or processes change.
In practice
Real-world examples
Example 1
A hotel pays its mortgage and property insurance whether it has 10 guests or 200. Laundry, breakfast and cleaning costs rise with each occupied room, so the hotel's profit improves sharply when occupancy increases. In a slow season, the same fixed costs make profit fall just as sharply.
Example 2
An online retailer pays a warehouse a base fee of $5,000 a month plus $1.50 per parcel shipped. Finance treats it as a mixed cost and models both parts in the forecast.
Example 3
A taxi operator has to hire another dispatcher for every 50 vehicles. That cost behaves as a step cost, so adding the 51st vehicle increases costs by a full salary. The owner therefore plans fleet growth in blocks of 50 rather than one car at a time.
Think of it
Think of a mobile phone plan. Your monthly line rental is a fixed cost that you pay even if you make zero calls. The extra charges for data overages represent variable costs that grow the more you use them.
Formula
Calculation
Total cost = fixed cost + (variable cost per unit x number of units)
A small manufacturer pays $18,000 a month in fixed costs and $6 per unit in variable costs. At 3,000 units, total cost = $18,000 + (3,000 x $6) = $18,000 + $18,000 = $36,000, which is $36,000 / 3,000 = $12 per unit. At 6,000 units, total cost = $18,000 + (6,000 x $6) = $18,000 + $36,000 = $54,000, or $54,000 / 6,000 = $9 per unit. Output doubled but total cost rose by only 50%, because the fixed element did not change.Case study
Seen in the real world
Silverline Print Works is an illustrative, fictional printer that priced jobs by dividing total monthly costs by the number of pages printed. In a quiet month, the price per page rose, and in a busy month it fell, which confused customers and the sales team.
The finance manager reviewed the cost behaviour. Of its $90,000 monthly costs, $60,000 was fixed, including machine leases and salaries, and the remaining variable cost was $0.03 per page.
She set a standard price based on a normal volume and a lower rate for large jobs that only needed to exceed the variable cost. In this illustrative example, understanding which costs moved with volume allowed the printer to quote fairly and to win extra work in slack periods.
Watch out
Common mistakes
- Treating all costs as variable and assuming that a 10% drop in sales reduces costs by 10%, when fixed costs stay in place.
- Assuming fixed costs are fixed forever, when they usually change outside the relevant range of activity.
- Using total cost per unit at one volume to price at another volume, which ignores that the fixed element is spread differently.
Questions
People also ask
Is a salary a fixed or variable cost?
Usually fixed, but if the pay includes a commission or bonus tied to sales, that part is variable. A salesperson's package is therefore often a mixed cost.
What is the relevant range?
It is the span of activity over which the assumed cost behaviour holds, such as production between 2,000 and 8,000 units a month. Forecasts outside that span need to be rebuilt with new assumptions.
Why does cost per unit fall as volume rises?
Because fixed costs are divided across more units, so each unit carries a smaller share of them.