Microeconomics | Fixed vs. Variable Costs | #economics

#economics Costs refer to amounts that have to be paid or spent in order to obtain or produce something. Oftentimes, the amount of a cost will vary depending on the firm. In economics, there are a few common ways to classify costs and compare them across different firms.

Microeconomics | Fixed and variable costs in economics | #economics

Economically, everything has its costs. Even if we do not carry out a certain activity in favour of another one, we incur costs for not doing it. Hence, it may be difficult sometimes to distinguish costs, not mentioning classifying them. There is, however, a commonly used framework to categorise costs, namely by identifying them as fixed and variable costs. This framework focuses on the relationship of cost to the volume of output.

Economics | Fixed Costs in Microeconomics

Fixed costs are independent of the volume of output an organization produces. These costs are sometimes referred to as ‘overhead.’ For example, a woodworking shop may sell one table or one hundred tables; a fixed cost won’t change based on these sales. Some examples of fixed costs include rent, insurance, utilities, and indirect labor costs. Indirect labor costs refer to costs from labor not directly tied to unit production, such as the salaries of leadership, the legal team, and human resources.

Economics | Variable Costs in Microeconomics

Variable costs change in proportion to the goods or services that are produced. For example, that same woodworking shop will need to spend more money for wood, screws, and hinges when demand increases for cabinets. This is because more of those materials are needed to complete the orders. Some examples of variable costs include raw materials and direct labour costs. Direct labour costs refer to costs from labor directly tied to unit production, such hourly labor for production and sales commissions.

Economics | Distinguishing between Fixed and Variable Costs in Microeconomics

While the designation of some costs as fixed or variable is straightforward, others may be more complex. If the woodworking shop hires a salaried supervisor to oversee operations as production increases, they may also need to spend more on electricity to keep the machines running for longer periods of time. In this example, is the supervisor salary fixed or variable? What about the cost of electricity?

Microeconomics | Fixed and variable costs in Economics

The supervisor salary could be considered variable because it is dependent upon higher production volumes. This might not happen at a single “unit“ level (e.g., one new supervisor for every 100 tables the shop must produce). Electricity may actually be part fixed and part variable cost; there is a fixed amount of electricity required to keep the shop open while there is incremental electricity required to run at a higher production rate.

There is an element of interpretation involved when drawing the line between fixed and variable costs. The difference is not always clear-cut. An firm's cost structure directly impacts its profitability. Having a foundational understanding of different types of costs will help you as you take on more complex financial analyses.