If you're evaluating a business's performance or creating forecasts, you need to know how to classify your expenses. These expenses make up the cost of running your business, but they are not all the same. Fixed costs typically remain constant, while variable costs change. You may also have to deal with mixed costs that combine fixed and variable elements. At some point, it might also be useful to know how step costs work.
Definition: Fixed Expenses
Fixed expenses are business costs that don't change in the short-term. You can identify a fixed cost by looking at how it behaves when other factors change around it. If there is no change to the cost, it is fixed. For example, your rental costs for office space do not change if you increase or decrease the number of employees working there. Your space stays the same, so you pay the same rent.
Examples of fixed costs include rent, property taxes, fixed salaries and insurance.
Definition: Variable Expenses
Variable costs respond to change. If other factors or activities increase or decrease a cost, it is variable. For example, if you buy a component that costs $1 and produce 100 items, the cost of purchase would be $100. If you increase production to 500 items, the cost increases to $500. Note that the unit cost in variable expenses typically stays the same -- it is the overall cost that changes.
Examples of variable costs include materials, supplies, wages paid by the hour and shipping costs.
Definition: Mixed Expenses
Mixed costs include both fixed and variable expenses. The fixed part of the cost stays the same from one period to the next, while the variable part changes based on certain activities or events. For example, if you pay salespeople both a salary and a commission on sales, the basic salary is a fixed cost and the commission is a variable cost. To use mixed costs in forecasting, you must be able to break them down into their fixed and variable parts.
Examples of mixed costs include telephone and telecommunication charges, vehicle operating costs, and machinery leasing with additional usage plans.
Definition: Step Costs
Step costs are expenses that do not change until activity reaches a specific and significant point or level. These expenses are constant until a trigger forces a change, at which point they take a step up or down before becoming constant again. For example, if you win a large order and need to hire more salaried employees to fulfill it, your salary costs take a step up to a new fixed cost level.
Examples of step costs include a change to the size of your business premises or a change in staffing levels.
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