Question 7.RQ.1: Define the terms fixed cost and variable cost. Explain how a...
Define the terms fixed cost and variable cost. Explain how an understanding of the distinction between fixed cost and variable cost can be useful to managers.
A fixed cost is one that is the same irrespective of the level of activity or output. Typical examples include rent of business accommodation, salaries of supervisory staff and insurance. A variable cost is one that varies with the level of activity or output. Examples include raw materials and labour, where labour is rewarded in proportion to the level of output. Note particularly that it is relative to the level of activity that costs are fixed or variable. A fixed cost will be affected by inflation and it will be greater for a longer period than for a shorter one.
For a particular product or service, knowing which element of cost is fixed and which is variable enables managers to predict the total cost for any level of activity. It also enables them to concentrate only on the variable cost in circumstances where a decision will not alter the fixed cost.