Money costs incurred by the firm are divided into fixed costs and variable costs. From the point of view of taking rational decision on production, the distinction between fixed costs and variable costs is very important.
As factors of production are divided into fixed factors (inputs) and variable factors (inputs), in corresponding to this cost are also divided into fixed costs and variable costs.
Fixed Costs:
Fixed Costs are those costs which are independent of the output. Output may be more or less or even zero fixed cost is incurred. It is a payment for fixed factors of production such as machineries, buildings, salaries of the staff, maintenance of machine, telephone, wages of watchman etc.
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These costs are incurred whatever may be the size of output. These costs are incurred before the factory starts production and after the factory close down its production for sometimes. Fixed costs are also called Supplementary Costs because these costs constitute a small portion of the total cost of production.
It is called Indirect Cost because the firm does not depend directly upon them. It is also called as the Overhead Cost of production because these costs decline per unit of output with increase in production.
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Variable Costs:
Variable Costs are those costs which are dependent on the level of output. Higher is the level of output greater will be the variable cost and vice-versa. It is the payment which is made to the variable factors of production which are found both in the short-run and long-run.
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It includes purchase of raw-materials, wages to labourers, etc. It is also called Prime Cost because this is the main cost of production. It is also called direct cost because it uses directly in the process of production.
The difference between variable and fixed costs is not rigid. It is one of degree not of kind. To take an example, the wage paid to typist is called fixed costs, if the services of typist are permanent.
If the services of the typist can be terminated when production stops this will be variable cost. Therefore, distinction is of degrees and only found in the short-run. In the long-run, every cost is variable costs.