Question

explain the importance of distinguishing between variable and fixed costs?

Answer 1

Fixed costs

Fixed costs are those costs that remain constant or remain unchanged for differing levels of activity. For eg, Rent of factory. Irrespective of the level of production carried out during the month, the rent as per the agreement has to be paid.

Variable costs

Variable costs are costs that varies with the level of output/activity. For eg, Material or Labour costs based on no.of units produced or labour hours.

Semi variable costs

Semi variable costs are those costs for which a part remains fixed and the other part varies as per the level of activity.

Why distinguishing between fixed and variable cost is important?

• Fixed costs will be incurred irrespective of the level of production.Hence while entering into agreements it is necessary to take into consideration the nature of costs and whether the cost benefit analysis shows it a viable option.These may be long term
• In case of fixed costs , the cost per unit of fixed cost varies as per the level of production since the cost as a whole remains constant. Hence, if there is optimum utilisation of production capacity, then the fixed cost pu. will have economies of scale.
• Variable costs incurred will depend on the levels of activity. But the per unit cost remains the same. It is crucial in the short run.
• By proper analysis of fixed and variable costs, companies may be able to make investing decisions on Property, Plant and Equipment. ( eg. if higher labour costs incurred on production, company can invest in machinery with fixed costs if there is enough sales to cover it)