Cost management is crucial to your business profit. Effective cost control starts from your understanding of cost behaviour - how a specific cost behaves in response to the change in the level of your business activities. Does it rise, fall, or remain constant as sales rise or fall? If a particular cost is expected to change, by how much will it change? To answer these questions, you must understand the difference between fixed costs and variable costs, the two main categories of costs based on cost behaviour.
Fixed costs:
A fixed cost is a cost that does not change in total despite changes in sales or productions. Rent is a typical example of fixed cost. Let's say, you operate a convenience store. You pay the same amount of rent no matter you sell one thousand items or you sell nothing. If you are a taxi driver, the insurance, the car payments, and the license fee are fixed costs. They stay the same whether you drive every day or take a month off.
Variable costs:
A variable cost is a cost that changes in total in proportion to changes in sales or productions. Raw material is a perfect example of variable costs of a manufacturing business. If you buy wood at $50 for each chair you build, then the total costs of wood should be $50 times the number of chairs you build. Another example is the gas expense for taxi driver. The more kilometres you drive, the more gas costs you.
Understanding the difference between fixed costs and variable costs is helpful for profitability analysis, budgeting, and making business decisions.
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