- Fixed costs
- Fixed costs are expenditures that do not change regardless of the level of production, because the fixed inputs behind them do not change in the short run.
- Variable costs
- Variable costs are the costs of the variable inputs, such as labour and raw materials, so they increase or decrease with output.
A fixed cost has to be paid even when output is zero
One example is the rent on a factory or a shop. Once you sign the lease, the rent is the same regardless of how much you produce, at least until the lease expires. Fixed costs take many other forms: machinery and equipment, research into new products, even advertising to build a brand name. At zero production the fixed costs are still there, so total cost starts from them rather than from nothing.
Check yourself
A factory's total cost is £5,000 in a month when it produces nothing, and £8,000 in a month when it produces 1,000 units. What are its fixed costs?
Variable costs rise and fall with the amount produced
The only way to increase or decrease output is by increasing or decreasing the variable inputs, so variable costs move with output. Labour is treated as a variable cost, since producing more typically requires more workers or more work hours, and raw materials count too. Total cost is the sum of the two: fixed costs plus variable costs, at every level of output.
Check yourself
Three of these are fixed costs for a café in the short run. Which one is a variable cost?
Can you think of a cost a bakery must pay even in a month when it bakes nothing?
A bakery pays £2,000 a month in rent on its shop and £150 a month to insure its ovens. Both are fixed: bake no loaves at all and both bills still arrive. Flour costs 30p a loaf, so 1,000 loaves need £300 of flour and 2,000 loaves need £600. The flour is variable, and so are the extra paid hours the second thousand loaves take.
If the landlord puts the rent up, doesn't the rent become a variable cost?
No. Variable means varying with output, not varying at all. A rent rise changes the size of the fixed cost, and the new rent is still the same whether the shop sells ten loaves or ten thousand. The slip that runs the other way is forgetting that fixed is a short-run idea. Once the lease can be ended or a second shop opened, every cost can change, so in the long run all costs are variable.
Ask one question of any cost: would it change if the firm produced more, or less, next month? If not, it is fixed. Then give the reason as well as the label. "Rent is fixed because it is paid whatever the output" earns the mark where "rent is fixed" may not. Watch for costs that follow output, such as overtime, packaging and fuel.
Check yourself
This chart shows a firm's costs in the short run. Label each line.
Curve A: Fixed cost. A is flat: the same at every level of output, including zero. A cost that does not change with output is fixed in the short run.
Curve B: Variable cost. B starts at zero and rises with output, because producing more needs more labour and more raw materials.
Curve C: Total cost. C starts where the flat line does and rises parallel to B: fixed cost plus variable cost at every level of output.
Exam question
A removals firm hires its vans by the day, only on days it has a job. Explain whether the cost of the vans is a fixed or a variable cost. [2]
Variable. Because the vans are hired only when there is work, the van bill rises with the number of jobs and falls to nothing when there are none.
One mark for variable and one for linking the cost to output. Had the firm bought the vans or leased them for a year, the same vans would be a fixed cost.
Fixed costs do not change with the level of production in the short run: rent, machinery, research and advertising are paid whether output is high, low or zero. Variable costs, such as labour and raw materials, increase or decrease with output. Total cost is fixed cost plus variable cost. A fixed cost can still change in size, and in the long run no costs are fixed at all.