Fixed costs are costs that are not related to the level of activity and which do not increase or decrease with the change in the level of activity.
For instance, if you make 1 unit or 10,000 units of a product in a rented factory, you’ll have to pay the same amount of rent. Therefore, rent is a fixed cost.
Variable costs are costs that are related to the level of activity and which increase or decrease with the corresponding increase or decrease in the level of activity.
For instance, if you need 2 kilograms of wood to make 1 chair, then you’ll need 200 kilograms of wood to make 100 chairs. More material cost will be incurred to make more units. Therefore, material cost is a variable cost.
Example
The following example further clarifies the behavior of fixed and variable costs with change in volume of production.
| Units Produced | Fixed Costs | Variable Costs @ $2 per unit | Total Costs |
| A | B | C = A x $2 | D = A + B |
| 500 | 2,500 | 1,000 | 3,500 |
| 1000 | 2,500 | 2,000 | 4,500 |
| 1500 | 2,500 | 3,000 | 5,500 |
| 2000 | 2,500 | 4,000 | 6,500 |
| 2500 | 2,500 | 5,000 | 7,500 |
| 3000 | 2,500 | 6,000 | 8,500 |
| 3500 | 2,500 | 7,000 | 9,500 |
| 4000 | 2,500 | 8,000 | 10,500 |
It can be seen that fixed cost graph is a horizontal line which means that total fixed cost is constant and is not affected by change in the production level. Whereas variable cost graph shows an increase in total variable cost with increase in the production level.