Fixed, variable and mixed costs: how costs behave when volume changes
Financial statements report what costs were. Management accounting asks what costs will be if something changes, and the first step is to sort costs by how they react to volume. This lesson sorts the costs of a fictional bicycle maker three ways, follows them into the cost of goods sold, and then uses Apple's and Microsoft's reported figures to show how cost behaviour can be estimated from two years of results.
- Level
- Beginner
- Reading time
- About 21 minutes
- Know this first
- What two share prices imply
By the end you will be able to:
- sort a cost as fixed, variable or mixed, and say how its total and its cost per unit respond to volume
- classify costs as direct or indirect and as product or period costs
- build prime cost, conversion cost, cost of goods manufactured and cost of goods sold
- split a mixed cost with the high-low method, and say how far the answer can be trusted
From what costs were to what costs will be
Everything so far in this course has been financial accounting: statements prepared to a common set of rules, so that outsiders such as investors and lenders can read them. Management accounting serves the people running the business. It has no required format, it looks forward as often as back, and it answers questions such as what happens to profit if sales fall by a fifth, whether a product should be dropped, or what a special order should be priced at. Almost every answer starts from the same step: knowing how each cost responds when volume changes.
This is the first of six lessons on the subject. It sorts costs by behaviour, then by whether they can be traced to a product and whether they belong in inventory, and ends by showing how the behaviour of a cost can be estimated from two periods of results. The running example is a fictional bicycle maker, invented for these lessons and not based on any real company. Apple and Microsoft appear near the end, to show that the same ideas can be applied to real statements and what the limits of doing so are.
Fixed, variable, mixed and step costs
A variable cost moves in direct proportion to activity. Frame tubing for a bicycle costs the same for each bicycle, so twice the output means twice the total, and the cost per bicycle stays the same. A fixed cost stays the same in total over the short term whatever the activity: the rent on the factory is paid whether it makes a thousand bicycles or ten thousand. Its cost per bicycle, though, moves the other way, falling as the same total is spread over more units.
A mixed cost has both parts. An electricity bill with a monthly connection charge plus a rate for each unit of power used is the standard example, and can be written as a total of a fixed amount plus a rate times the activity. A step cost is fixed over a range and then jumps: one inspector can check a certain number of bicycles a day, and past that a second inspector must be hired.
All of these statements are true only within a relevant range, the span of activity over which the cost pattern holds. Rent is fixed until the factory is full and a second building is needed. The lessons that follow treat the pattern as a straight line within the range, which is how the method is normally used, and the calculator below stays inside a range of 500 to 20,000 bicycles.
Watch cost per bicycle as volume changes
The fictional maker has fixed costs of $240,000 a year, covering factory rent and supervision, head-office salaries and advertising, and variable costs of $125 for each bicycle, covering parts, assembly labour and sales commission. Change the volume, the fixed costs and the variable cost per bicycle. The left page shows the totals and the right page the cost for each bicycle, with the fixed and variable parts separated.
At 8,000 bicycles a year the total cost is $1,240,000: $240,000 fixed and $1,000,000 variable. Each bicycle costs $155.00, of which $30.00 is fixed cost spread over the volume. Doubling output would bring the cost per bicycle to $140.00, but never below the variable cost of $125.00.
Four experiments. First, at the starting settings of 8,000 bicycles the total cost is $1,240,000, of which $240,000 is fixed and $1,000,000 variable, and each bicycle costs $155.00. Second, double the volume to 16,000: the fixed cost per bicycle halves from $30.00 to $15.00 and the total per bicycle falls to $140.00, though total cost rises. Third, cut the volume to 2,000 and the cost per bicycle jumps to $245.00, with 49% of the total now fixed. Fourth, raise the volume to the maximum of 20,000 and the cost per bicycle falls to $137.00, closer to the variable cost of $125 but never reaching it. The point of the exercise is that a single cost per unit is a figure for one volume only. Quote it without its volume and it can mislead.
Three ways to sort the same cost
Behaviour is one way to classify a cost, and there are two others that answer different questions. A cost is direct if it can be traced to a particular product or other cost object economically, as tubing can to a bicycle, and indirect if it is shared and has to be allocated, as factory rent is. And a cost is a product cost if it is incurred in making the goods, in which case it is held in inventory until the goods are sold, or a period cost if it is charged to the income statement in the period it occurs, as selling and administration usually are. The three questions are independent: a sales commission is variable, can be traced to a sale, and is a period cost.
| Cost, for 8,000 bicycles | Amount | Behaviour | Traced to a bicycle | Product or period |
|---|---|---|---|---|
| Frame tubing and components | $720,000 | Variable | Direct | Product |
| Assembly labour | $240,000 | Variable | Direct | Product |
| Factory rent, supervision and depreciation | $150,000 | Fixed | Indirect | Product |
| Sales commission | $40,000 | Variable | Direct | Period |
| Head-office salaries | $50,000 | Fixed | Indirect | Period |
| Advertising | $40,000 | Fixed | Indirect | Period |
| Total cost incurred | $1,240,000 |
The table sums to $1,240,000, the same total as the calculator at 8,000 bicycles. Note that the same cost can be described in all three ways at once, and that a person asking whether a cost is fixed is not asking whether it is a product cost.
From manufacturing cost to cost of goods sold
Product costs have names of their own. Direct materials and direct labour together are prime cost, $960,000 for the bicycle maker. Direct labour and factory overhead together are conversion cost, the cost of turning materials into finished goods, $390,000. Adding materials, labour and overhead gives total manufacturing cost of $1,110,000, whichever way it is grouped. The schedule below carries it through inventory to the figure that appears on the income statement.
| Schedule of costs, fictional bicycle maker | Amount |
|---|---|
| Direct materials used | $720,000 |
| Direct labour | $240,000 |
| Prime cost | $960,000 |
| Factory overhead | $150,000 |
| Total manufacturing cost | $1,110,000 |
| Add work in progress at the start | $60,000 |
| Less work in progress at the end | (90,000) |
| Cost of goods manufactured | $1,080,000 |
| Add finished goods at the start | $100,000 |
| Less finished goods at the end | (150,000) |
| Cost of goods sold | $1,030,000 |
The cost of goods manufactured is $1,080,000, and the cost of goods sold $1,030,000. The $130,000 of sales commission, head-office salaries and advertising is charged straight to the period, so the costs expensed in the year add up to $1,160,000. That is $80,000 less than the $1,240,000 incurred, and the difference is the build-up of work in progress and finished goods that has been carried forward on the balance sheet. A business can therefore spend more than it expenses in a year, which is one reason profit and cash can differ.
Estimating behaviour from the numbers
In practice, the books record total costs and do not label them fixed or variable. The labels are estimated. The simplest method is the high-low method: take the period with the highest activity and the period with the lowest, divide the change in cost by the change in activity to get the variable rate, and subtract the variable part from either period's cost to get the fixed part.
Take the electricity bill of a small workshop. In a month when it made 800 units the bill was $3,600, and in a month when it made 1,400 units it was $4,800. The variable rate is ($4,800 − $3,600) ÷ (1,400 − 800) = $2.00 per unit. The fixed part is $3,600 − $2.00 × 800 = $2,000 a month, and the check at the other point, $4,800 − $2.00 × 1,400, gives the same. So the bill is $2,000 plus $2.00 for each unit. The method uses only two points, so its answer can be far from the truth if either month was unusual. Plotting the data, or fitting a line through all of it by regression, is more reliable when there are many periods.
The same idea on Apple and Microsoft
Neither company reports its costs split into fixed and variable. But total costs, which are revenue less operating income, are known for both years in the statements used throughout this course, and a two-point estimate can be made in the same way. The table treats revenue as the activity.
| Two-point estimate, fiscal 2024 to 2025, $ billion | Apple | Microsoft |
|---|---|---|
| Revenue, fiscal 2024 | 391.0 | 245.1 |
| Revenue, fiscal 2025 | 416.2 | 281.7 |
| Total costs, fiscal 2024 (revenue less operating income) | 267.8 | 135.7 |
| Total costs, fiscal 2025 | 283.1 | 153.2 |
| Extra cost for each extra dollar of revenue | 60.9¢ | 47.8¢ |
| Average cost for each dollar of revenue, fiscal 2025 | 68.0¢ | 54.4¢ |
| Implied fixed part of costs | 29.8 | 18.4 |
Each extra dollar of revenue came with about 60.9 cents of extra cost at Apple and 47.8 cents at Microsoft, well below the average costs of 68.0 and 54.4 cents for each dollar of revenue. That is what a cost base with a fixed part looks like: costs rose, but by less than revenue, so margins widened. The fixed parts implied are $29.8 billion and $18.4 billion, and one minus each rate, 39.1% and 52.2%, is the share of an extra dollar that is left after the extra costs. The next lesson calls that the contribution margin.
Treat these as illustrations, and not as measurements. They rest on two years only. Costs at companies like these include big discretionary items such as research, which management sets and does not simply let follow sales. Prices and the mix of products change between years. And Microsoft's cash flow statement shows $69.1 billion spent on acquisitions in fiscal 2024, so part of its rise in costs between the two years may come from businesses bought and not from ordinary cost behaviour. A real analysis would use many periods, strip out such items, and test the line against the data.
What this classification cannot tell you
- Behaviour depends on the time frame. Over a few days most costs are fixed; over several years almost all can be changed. Fixed and variable are descriptions of a particular period and range.
- The labels are judgements. Whether a supervisor's salary is fixed or step, or whether labour is variable or fixed, depends on how the firm hires and how flexible its contracts are.
- The straight-line pattern is an approximation. Real costs bend, with quantity discounts, overtime rates and capacity limits.
- Cost per unit hides volume. A per-unit figure holds for one level of output. It is not a price list.
- Allocation is not behaviour. A fixed overhead spread over units can look variable on a report. Check what drives the cost.
Common mistakes
Treating cost per unit as constant
Only the variable part is constant. The fixed part per unit moves with volume, so the total per unit does too.
Calling a cost fixed because it is large
Size does not decide behaviour. A very large cost, such as materials, can be entirely variable.
Mixing up direct and variable
A direct cost can be traced to a product. A variable cost changes with activity. A factory supervisor is indirect and fixed; a sales commission is direct and variable. The two scales are independent.
Treating all costs incurred as costs of the period
Product costs sit in inventory until the goods are sold. The cost incurred in a year and the cost expensed in it are different numbers when inventory changes.
Trusting a two-point estimate
The high-low method uses the extremes, which are often the unusual months. Check it against other periods before relying on it.
Try it yourself
1. A cost has a fixed part of $60,000 a year and a variable part of $8 per unit. What is the total at 5,000 units, and what is the cost per unit?
Show the working
Total = 60,000 + 8 × 5,000 = $100,000. Per unit = 100,000 ÷ 5,000 = $20. At 10,000 units the total is $140,000 and the cost per unit $14, lower because the fixed part is spread more widely.
2. A factory uses $50,000 of direct materials, $30,000 of direct labour and has $20,000 of factory overhead. What are its prime cost and conversion cost?
Show the working
Prime cost = materials + labour = 50,000 + 30,000 = $80,000. Conversion cost = labour + overhead = 30,000 + 20,000 = $50,000. Total manufacturing cost is $100,000 either way: prime cost plus overhead, or materials plus conversion cost.
3. In the lowest month a workshop made 1,000 units at a cost of $7,000. In the highest it made 3,000 units at $11,000. Use the high-low method to find the variable cost per unit and the fixed cost.
Show the working
Variable rate = (11,000 − 7,000) ÷ (3,000 − 1,000) = $2 per unit. Fixed cost = 7,000 − 2 × 1,000 = $5,000. Check at the high point: 5,000 + 2 × 3,000 = $11,000.
4. Why does the cost per unit fall as volume rises, even though the total cost rises?
Show the working
The variable cost per unit stays the same, but the fixed cost is shared among more units. Total cost goes up by the variable cost of the extra units, while the fixed part of each unit's cost goes down.
Where this is used
- A manager builds a budget by splitting each cost into a fixed amount and a rate, then applying the expected volume.
- A pricing team sets a minimum price from the variable cost, and checks how much fixed cost each sale must help cover.
- A finance team studies how costs reacted to a past fall in sales to judge how much of the cost base could be reduced.
- An analyst reads two years of reported results to guess how profit would respond to a change in revenue.
Key terms
- Management accounting
- Accounting information prepared for managers' decisions, in whatever form is useful.
- Variable cost
- A cost whose total changes in proportion to activity.
- Fixed cost
- A cost whose total stays the same over a relevant range of activity.
- Mixed cost
- A cost with a fixed part and a variable part.
- Step cost
- A cost that is constant over a range of activity and jumps at the edges.
- Relevant range
- The span of activity over which a cost pattern holds.
- Direct and indirect costs
- Costs that can, or cannot, be traced to a product or other cost object.
- Product and period costs
- Costs held in inventory until goods are sold, and costs charged to the period in which they occur.
- Prime cost and conversion cost
- Direct materials plus direct labour, and direct labour plus factory overhead.
- High-low method
- Estimating fixed and variable parts from the periods of highest and lowest activity.
Questions people ask
Is labour a fixed or a variable cost?
It depends on how it is paid and how easily it can be changed. Piece-rate or hourly labour that can be flexed with output is variable. Salaried staff on long contracts are fixed over the short term. The classification follows the contract and the time frame.
Why does management accounting not follow set rules like financial accounting?
Its readers are inside the business and can ask for whatever helps them decide, so reports can take whatever form suits the decision. They are normally kept consistent with the financial statements, but nothing requires a set format.
Is a regression better than the high-low method?
With enough periods, usually yes, because it uses all the data and not the two extremes. The high-low method is quick, and a good first check.
Why use a fictional company for the mechanics?
Real companies do not publish cost behaviour. A fictional business lets every number be known and checked. The real statements then show how the ideas apply and where the estimates run out.
Sources and review
- Apple Inc., Form 8-K, Exhibit 99.1: fourth quarter and full-year fiscal 2025 results, filed with the US Securities and Exchange Commission. Source of Apple's statements.
- Microsoft Corporation, Form 8-K, Exhibit 99.1: fourth quarter and fiscal year 2025 results, filed with the US Securities and Exchange Commission. Source of Microsoft's statements.
- OpenStax, Principles of Accounting, Volume 2: Managerial Accounting, section 2.2: Identify and apply basic cost behavior patterns, for the definitions of fixed, variable, mixed and step costs and the relevant range.
- OpenStax, Principles of Accounting, Volume 2: Managerial Accounting, section 2.3: Estimate a variable and fixed cost equation and predict future costs, for the high-low method and its limits.
How the numbers were checked: every cost line, subtotal and schedule for the fictional maker was recomputed in plain code and tied to the calculator's totals, including the check that costs incurred less costs expensed equal the change in inventories. The two-point estimates for Apple and Microsoft were rebuilt from the filed income statements, and the calculator, which runs separately, was compared with that code across a grid of inputs.