Fixed cost

In economics, fixed costs are business expenses that are not dependent on the level of goods or
services produced by the business [1] They tend to be time-related, such as salaries or rents being
paid per month, and are often referred to as overhead costs. This is in contrast to variable costs,
which are volume-related (and are paid per quantity produced).

In management accounting, fixed costs are defined as expenses that do not change as a function
of the activity of a business, within the relevant period. For example, a retailer must pay rent and
utility bills irrespective of sales.

Along with variable costs, fixed costs make up one of the two components of total cost: total cost
is equal to fixed costs plus variable costs.

One can decompose total costs as the sum of fixed costs

and variable costs. In the Cost-Volume-Profit Analysis model, total costs are linear in volume.

Areas of confusion

Fixed costs should not be confused with sunk costs. From a pure economics perspective, fixed
costs are not permanently fixed; they will change over time, but are fixed in relation to the
quantity of production for the relevant period. For example, a company may have unexpected
and unpredictable expenses unrelated to production; and warehouse costs and the like are fixed
only over the time period of the lease.

By definition, there are no fixed costs in the long run.[citation needed] Investments in facilities,
equipment, and the basic organization that can't be significantly reduced in a short period of time
are referred to as committed fixed costs. Discretionary fixed costs usually arise from annual
decisions by management to spend on certain fixed cost items. Examples of discretionary costs
are advertising, machine maintenance, and research & development expenditures.[2]

In business planning and management accounting, usage of the terms fixed costs, variable costs
and others will often differ from usage in economics, and may depend on the intended use. Some
cost accounting practices such as activity-based costing will allocate fixed costs to business
activities, in effect treating them as variable costs. This can simplify decision-making, but can be
confusing and controversial.[3] [4]

In accounting terminology, fixed costs will broadly include almost all costs (expenses) which are
not included in cost of goods sold, and variable costs are those captured in costs of goods sold.
The implicit assumption required to make the equivalence between the accounting and
economics terminology is that the accounting period is equal to the period in which fixed costs
do not vary in relation to production. In practice, this equivalence does not always hold, and
depending on the period under consideration by management, some overhead expenses (e.g.,
sales, general and administrative expenses) can be adjusted by management, and the specific
allocation of each expense to each category will be decided under cost accounting.

Variable cost
Variable costs are expenses that change in proportion to the activity of a business.[1] Variable
cost is the sum of marginal costs over all units produced. It can also be considered normal costs.
Fixed costs and variable costs make up the two components of total cost. Direct Costs, however,
are costs that can easily be associated with a particular cost object.[2] However, not all variable
costs are direct costs. For example, variable manufacturing overhead costs are variable costs that
are indirect costs, not direct costs. Variable costs are sometimes called unit-level costs as they
vary with the number of units produced.

Direct labor and overhead are often called conversion cost,[3] while direct material and direct
labor are often referred to as prime cost

Explanation

For example, a manufacturing firm pays for raw materials. When activity is decreased, less raw
material is used, and so the spending for raw materials falls. When activity is increased, more
raw material is used and spending therefore rises. Note that the changes in expenses happen with
little or no need for managerial intervention. These costs are variable costs.

A company will pay for line rental and maintenance fees each period regardless of how much
power gets used. And some electrical equipment (air conditioning or lighting) may be kept
running even in periods of low activity. These expenses can be regarded as fixed. But beyond
this, the company will use electricity to run plant and machinery as required. The busier the
company, the more the plant will be run, and so the more electricity gets used. This extra
spending can therefore be regarded as variable.

In retail the cost of goods is almost entirely a variable cost; this is not true of manufacturing
where many fixed costs, such as depreciation, are included in the cost of goods.

Although taxation usually varies with profit, which in turn varies with sales volume, it is not
normally considered a variable cost.
For some employees, salary is paid on monthly rates, independent of how many hours the
employees work. This is a fixed cost. On the other hand, the hours of hourly employees can often
be varied, so this type of labour cost is a variable cost.

Total cost
In economics, and cost accounting, total cost (TC) describes the total economic cost of
production and is made up of variable costs, which vary according to the quantity of a good
produced and include inputs such as labor and raw materials, plus fixed costs, which are
independent of the quantity of a good produced and include inputs (capital) that cannot be varied
in the short term, such as buildings and machinery. Total cost in economics includes the total
opportunity cost of each factor of production as part of its fixed or variable costs.

The rate at which total cost changes as the amount produced changes is called marginal cost.
This is also known as the marginal unit variable cost.

If one assumes that the unit variable cost is constant, as in cost-volume-profit analysis developed
and used in cost accounting by the accountants, then total cost is linear in volume, and given by:
total cost = fixed costs + unit variable cost * amount.

The total cost of producing a specific level of output is the cost of all the factors of input used.
Conventionally economist use models with two inputs capital, K. and labor, L. Capital is
assumed to be the fixed input meaning that the amount of capital used does not vary with the
level of production. The rental price per unit of capital is denoted r. Thus the total fixed costs
equal Kr. Labor is the variable input meaning that the amount of labor used varies with the level
of output. In fact in the short run the only way to vary output is by varying the amount of the
variable input. Labor is denoted L and the per unit cost or wage rate is denoted w so the total
variable costs is Lw. Consequently total cost is fixed costs (FC) plus variable cost (VC) or TC =
FC + VC = Kr +wL.

Other economic models have the total variable cost curve (and therefore total cost curve)
illustrate the concepts of increasing, and later diminishing, marginal returns.
The total cost curve, if non-linear, can represent increasing and diminishing marginal returns.

Direct cost : A cost that can be directly traced

to producing specific goods or services.
A direct cost is a cost that is directly attributable to the manufacture of a product (or provision of
a service).

A good example of a direct cost is the cost of the materials needed to make a product. The usage
of the materials is directly related to the manufacture of the product.

Direct costs are very often variable costs and vice-versa, but the two are not synonymous: for
example, the costs of running machinery used in manufacturing are not direct costs, but they are
likely to be variable or semi-variable.

There are three types of direct cost:

 direct materials,
 direct labour, and
 direct expenses.

The last is anything that does not fall into the other two (commoner) categories.

A method for tracking the cost of materials needs to be chosen: usually FIFO or LIFO,
sometimes average cost or replacement cost.

The sum of all three types of direct costs is called the prime cost.

Any cost that is not a direct cost is an indirect cost.

Direct cost is closely related to cost of goods sold, but is not necessarily the same (it may be in
some businesses). Direct cost is a management accounting measure and can be calculated
in the way that the management find most useful. Cost of sales is a financial accounting number
and must be calculated in accordance with accounting standards.

In general, direct cost, is measured very narrowly, so related numbers such as cost of sales are
likely to be higher as they will include some indirect costs that can be attributed to products.
Indirect costs
Indirect costs are costs that are not directly accountable to a cost object (such as a particular function or
product). Indirect costs may be either fixed or variable. Indirect costs include taxes, administration,
personnel and security costs, and are also known as overhead.

Indirect vs. Direct costs

Direct costs are those for activities or services that benefit specific projects, e.g., salaries for
project staff and materials required for a particular project. Because these activities are easily
traced to projects, their costs are usually charged to projects on an item-by-item basis.

Indirect costs are those for activities or services that benefit more than one project. Their precise
benefits to a specific project are often difficult or impossible to trace. For example, it may be
difficult to determine precisely how the activities of the director of an organization benefit a
specific project. Indirect costs do not vary substantially within certain production volumes or
other indicators of activity, and so are considered to be fixed costs.[1]

It is possible to justify the handling of almost any kind of cost as either direct or indirect. Labor
costs, for example, can be indirect, as in the case of maintenance personnel and executive
officers; or they can be direct, as in the case of project staff members. Similarly, materials such
as miscellaneous supplies purchased in bulk—pencils, pens, paper—are typically handled as
indirect costs, while materials required for specific projects are charged as direct costs.

Examples

Costs usually charged directly

 Project staff
 Consultants
 Project supplies
 Publications
 Travel
 Training

Costs either charged directly or allocated indirectly

 Telephone charges
 Computer use
 Project clerical personnel
 Postage and printing
 Miscellaneous office supplies
Costs usually allocated indirectly

 Utilities
 Rent
 Audit and legal
 Administrative staff
 Equipment rental