Fixed costs do not change with output, variable costs do, and total cost is the two added together.
Costs of production are what a firm pays to make its output. Fixed costs (FC) do not change when output changes, at least in the short run. Rent, insurance and loan repayments are examples. A firm pays them even if it produces nothing.
Variable costs (VC) change directly with output. Raw materials, packaging and electricity for machines are examples. If output is zero, variable cost is zero.
Total cost (TC) is fixed cost plus variable cost: TC = FC + VC.
On a diagram, FC is a flat line. VC starts at zero and rises with output. TC starts at the level of FC and rises alongside VC.
- Fixed cost (FC)
- Does not change with output; e.g. rent.
- Variable cost (VC)
- Changes with output; e.g. raw materials.
- Total cost (TC)
- TC = FC + VC.
Worked example: Classifying a bakery's costs
A bakery pays $3,000 a month in rent and $0.40 in ingredients for each loaf.
- Fixed cost: rent of $3,000, paid whatever the output.
- Variable cost: if it bakes 5,000 loaves, ingredients cost 5,000 x $0.40 = $2,000.
- Total cost: $3,000 + $2,000 = $5,000.
- If output doubles to 10,000 loaves, VC rises to $4,000 and TC to $7,000, but FC stays $3,000.
Watch out for this
Fixed costs never change.
Fixed costs do not change with output. They can still change for other reasons: a landlord can raise the rent.
Check your understanding
Which is a variable cost for a car factory?
- Steel used to build each car
- Rent on the factory building
- Insurance on the building