Fixed costs are expenses that remain the same and do not vary with production or sales levels. Examples include rent, property, converting fixed costs to variable costs, taxes, insurance, and advertising, all which remain constant regardless of the activity. Variable costs are expenses that change in proportion with activity or volumes, or which directly depend on the volume of sales or production. For instance, the cost of raw material depends on the production volume, and higher the raw materials procured, the better the economies of scale leading to reduced handling costs, and vice versa.
Variable costs remain the same per unit of production. Traditional managerial accounting divides fixed costs equally to the number of units manufactured or sold, or considers it separately to determine overall profit or loss. In this scenario, the higher the volume, the lower the fixed cost appropriation per unit, and lower the volume, the higher the fixed cost appropriation per unit of production.
In a strict sense, all costs vary over time and no cost is a purely fixed cost. For instance, lower production volumes would mean underutilization of the factory and ultimate shifting to smaller premises, and thereby, lesser rent. Production of more units would mean more investment and stakes, and hence higher insurance premiums, and the like. The concept of fixed costs is, therefore, relevant only in the short term, usually for the specific accounting period.
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