A couple months ago, I wrote about the due diligence process that a company should go through in deciding its prospective business relationships. In that column, I made a suggestion in the cost economics section that it is a good idea to look at your costs and determine if you want some of your costs to be fixed and some of them to be variable. But I did not explain what that means or why it is a good idea. So I thought it would be a good idea to discuss that this month: what's the difference between fixed and variable costs, and why would you want some costs to be one or the other?
The distinction between variable costs and fixed costs is necessary to address basic questions, such as how much would the cost-of-goods-sold change if the output level increases by five percent? A variable cost changes in total in proportion to changes in the related level of total activity or volume. A fixed cost remains unchanged in total for a given time period, despite wide changes in the related level of total activity or volume.