In general, we have three types of costs, Fixed Costs, Variable Costs, and the sum of the two, Total Costs. Let’s look at each one in detail.
Fixed Costs
Fixed Costs are costs that are independent of how much or how little firms produce. Like it says in the name, the costs are fixed, they don’t change with the quantity of goods produced.
Think of things like rent, equipment leases, management, salaries, all those expenses firms must incur and that don’t depend on how the quantity of goods produced. Even if a firm does not produce any output at all, which is a different way of saying zero output, BAM!, it still incurs them.
Pause & Reflect
Which sentence is true?
- Fixed costs are “fixed” because they don’t change as time goes by.
- Fixed costs are “fixed” because they reoccur on the same date from year to year.
- Fixed costs are “fixed” because they don’t change with the quantity of output produced.
Naturally, you could say “wait a minute, what if firms start paying higher rents, or decide to move to a different location, add stores, buy equipment, hire more salaried workers?”, will that not change fixed costs? That’s a great point, and any of those changes would certainly increase the amount of fixed costs, but their nature would nonetheless not change, and that is that the firm would still have to pay them, even if now more, regardless of the amount of goods produced.
Finally, and to really drive the point home, think of the salaries paid to workers while a firm closes for vacation. Does a firm still pay them even if it closes its doors for a couple of weeks? If your answer is yes, that is a fixed cost.
Fixed Costs & The Long & Short Run
Finally, and for completeness… fixed costs are a short run type of thing, they don’t exist in the long run. What do I mean by short run versus long run?
Unfortunately, I can’t give you an exact time span, say the short run lasts for 73 months, because it changes from firm to firm. But here is what I can say: for economists, the long run is the time frame such that firms can close doors and call it quits, or new firms can come in, or existing firms have just enough time to completely change their scale (get smaller, bigger, or stay the same). It is this moment in time, when all is up in the air to be decided, and the decision to produce or not produce (that is the question) may mean some costs or none at all, that is the long run.
Variable Costs
Variable Costs are costs that depend on how much a firm produces or sells. In other words, they vary directly with the amount of the goods produced.
Think of things like the direct inputs in production, and those are the raw materials that go into making a product, billable hours, commissions, even shipping charges, or freight. The more a firm produces, the higher the variable costs it incurs and the less a firm produces, the lower the variable costs it incurs. In the extreme of a firm not producing anything at all, zero, nada, it also does not have any variable costs, which are, you know it, also zero or nada.
Pause & Reflect
Which sentence is true?
- Variable costs are “variable” because they change as time goes by.
- Variable costs are “variable” because they reoccur in different dates in a year.
- Variable costs are “variable” because they change with the quantity of output produced.
- Variable costs are “variable” because they are a quantity that may assume any one of a set of values.
Fixed or Variable?
To ensure we’re on the same page, fill in the following blanks (solutions at the bottom of the page).
1. _____ costs are costs that do not vary with the amount of goods produced.
2. _____ costs are costs that increase with the amount of goods produced.
3. A firm that produces a zero amount of goods nonetheless incurs ______ costs; it does not incur any _____ costs.
4. If a firm produces a zero quantity of output, it’s profit will be equal to _ costs.
5. List two examples of fixed costs. What made you choose these examples?
5. List two examples of variable costs. What made you choose these examples?
Now let’s look at two examples.
Zita’s Bakery makes the best bread in town. She uses only the best ingredients: active dry yeast, water, sugar, Celtic sea salt, organic olive oil, and fresh all-purpose flour. She rents her store and leases two mixers, three blenders, and four commercial ovens. The ovens need to be warm all day when she bakes, so she has steep electricity bills. Judite works at the bakery, she’s been an employee for many years. Finally, sometimes Zita hires Fatima to help when times are especially busy; she is paid by the hour.
Classify the following as fixed costs or variable costs (solutions at the bottom of the page).
Ingredients like the active dry yeast, water, sugar, Celtic sea salt, organic olive oil, and fresh all-purpose flour are a _____ cost.
Rent is a _____ cost.
Leased mixers, blenders, and ovens are a _____ cost.
Electricity is a _____ cost.
Judite is a _____ cost.
Fatima is a _____ cost
Call Us Right Meow! is a call center that offers technical support to the technology-challenged customers of a popular electronics store. It takes calls Monday through Friday from 9 AM to 5 PM and is also open Saturday and Sunday from 8 AM to 12 PM during the holidays. It rents two floors of a building in Phoenix, AZ, where hourly workers answer phones using leased computer terminals. Workers have free M&M’s at their disposal; workers find them fresh every morning and afternoon. Management consists of two people, Jim and Dwight.
Classify the following as fixed costs or variable costs (solutions at the bottom of the page).
Rent on the two floors is a _____ cost.
Hourly workers are a _____ cost.
Leased computer terminals are a _____ cost.
M&M’s are a _____ cost.
Jim and Dwight are a _____ cost.
Total Costs
This is the sum of the other two costs. So,
TC = VC + FC
Solutions
1. Fixed costs are costs that do not vary with the amount of goods produced.
2. Variable costs are costs that increase with the amount of goods produced.
3. A firm that produces a zero amount of goods nonetheless incurs Fixed costs; it does not incur any Variable costs.
Zita’s Bakery
Ingredients like the active dry yeast, water, sugar, Celtic sea salt, organic olive oil, and fresh all-purpose flour are a Variable cost.
Rent is a Fixed cost.
Leased mixers, blenders, and ovens are a Fixed cost.
Electricity is a Variable cost (at least the variable part of the bill, that depends on the kilowatts consumed).
Judite is a Fixed cost.
Fatima is a Variable cost.
Call Me Right Meow!
Rent on the two floors is a Fixed cost.
Hourly workers are a Variable cost.
Leased computer terminals are a Fixed cost.
M&M’s are a Variable cost.
Jim and Dwight are a Fixed cost.
Joana Girante 