All expenses of an organization can be classified as variable costs, fixed costs, or mixed costs. This classification is used for internal analysis to determine more efficient business operations. These classifications are typically used in settings where products are made, but they can be utilized in any business setting.
A variable cost is cost that changes as the underlying quantity changes. For example, consider a small business that crochets blankets. If more blankets are to be made, more yarn must be purchased. Yarn is a variable cost, because the final total cost of the yarn varies depending on how many blankets are produced. Variable costs are entirely controllable for a company; if a business wants to reduce expenses, it can do so by slowing production and incurring variable expenses. In addition, the contribution margin calculation is based around variable costs.
A fixed cost is a set expense that does not change over a relevant range. A relevant range is a range of parameters that can be increased but only at an additional price. For example, the crochet company has one warehouse to store the finished products. The warehouse has a fixed rent cost of $500 per month. By paying this fixed $500 per month, the company can store a set number of blankets. If the number of blankets it needs to store exceeds a certain amount or goes beyond the relevant range of only having one warehouse the company will need to incur an additional fixed cost for additional warehouse space.
A mixed cost is an expense that has both fixed and variable components. Frequently, there is a fixed flat charge assessed and an additional fee based on activity. For example, the company may have a contract with a shipping company. By paying $75 per month and $5 per shipment, the company will distribute all sales. The $75 portion of the cost is fixed, and the $5 per shipment is variable, so the shipping expense is mixed.
Usefulness of Cost Classifications
The elements above directly tie into what a company should charge per item. If the pricing of a good does not at least cover the variable costs plus a small portion of the fixed costs, the company can never break even or turn a profit. Therefore, a company should consider the costs that go into a product in addition to the hidden fixed costs that it must allocate to the product’s price. The information is most useful for internal management of production companies because it assists with business expansion opportunities. If the crochet blanket company wants to expand, how much would it cost? By focusing only on fixed costs and understanding that it has complete control over variable costs, it can determine the answer fairly quickly. Although tracking variable, fixed, and mixed costs are not required by any external party, a company can utilize the information these cost classifications can offer.