In accounting, costs can be classified in a number of ways. A very important cost classification involves separating charges according to how they respond to changes in activity level. Fixed costs (FC) and variable costs (VC) represent the dichotomy in this classification. At risk of over-simplifying the definition, FCs are those that remain constant regardless of the level of activity; VCs are those that tend to vary with the level of activity.
One can correctly argue that no charge is guaranteed to remain fixed over a protracted period. For example, rent is usually cited as an FC. However, rent can increase or decrease over time, although it does not regularly fluctuate. Commercial insurance is another example of a charge that can easily fluctuate, even though it remains fixed for a defined period. To account for this, FCs are also called period charges. One definition of them posits that they are attached to a particular period and does not vary within certain activity levels. Therefore, in a limited context, we can identify a period charge. In the long run, all costs are variable.
Examples of period charges include insurance, depreciation (using the straight-line method) and salaries. VCs must vary with output or activity. Therefore, examples include direct materials for production, sales commissions and overtime payments. Not all charges in a specific period can be classified as either fixed or variable. Some costs are mixed/ semi-variable/ semi-fixed. An example of a semi-variable cost includes utilities, where there is usually a fixed charge and additional charges that vary according to consumption.
Within a period, there are costs that arise once certain levels of activity are passed. They cannot be classified as a VC, because they remain fixed within certain levels of activity. These are step costs; those that remain fixed within a certain activity level. A good example of this is tyre replacement. Tyres would only be replaced after a certain mileage and the costs would be fixed for that period. Every time the requisite mileage for replacement is reached, the tyres must be replaced.
It is important to note that while a period charge is constant over a period and variable costs generally rise, the fixed and variable costs per unit do the opposite. The FC per unit decreases as the activity level increases, while the VC per unit remains constant, since each additional unit contributes the same marginal amount. Fixed costs and variable costs comprise the total cost of a product, service or activity. They can also be represented in the linear equation:
TC = FC + VC per unit (output/ activity level).
There are different ways of classifying costs in cost and management accounting. One of these is direct and indirect costs.