Fixed costs:

A fixed cost is a cost that remains constant in total, regardless of changes in the level of activity. As the activity level rises and falls, the fixed cost remains constant in total amount unless influenced by some outside force, Such as price changes. There are two types of fixed cost.

(1) Committed fixed cost: Committed fixed costs relate to the investment in facilities, equipment and the basic organizational structure of a firm. Example: Rent.

(2) Discretionary fixed cost: Discretionary fixed cost usually arise from annual decisions by management to spend in certain fixed cost areas. Example: Advertising.

Role in decision-making

Usually fixed cost is used to determine break-even point. The formula for break-even point is = fixed cost  Cm per unit.
Suppose our fixed cost       = $ 20,000
                     Selling price  = $ 250
                     Variable cost = $ 150
Then break-even unit = {20,000  (250 – 150)}
                                   = 200 unit
In the break-even point there is no profit as well as no loss at all. We have calculated break-even point to determine the sales level and using this method we can also calculate the number of unit to gain our expected profit.
Reduction of fixed cost is also very important to increase net income. If we reduce fixed cost per unit then it will contribute to net income. Suppose our production is not running in our full capacity level then we can increase production in order to reduce our fixed cost per unit. For example:
Capacity:         400 Units
Production:     300 Units
Fixed cost:      $20,000
Variable cost:  $150
Selling price:   $250

      Current income statement
Sales          =             $75,000
(300 250)
(-) V. cost           =             $45,000
(300150)                        
Cm                                     $30,000
(-) F. cost           =              $20,000
Net income                        $10,000
                                        
Here we see that in the current situation we have a net income of $10,000. Now we get an offer from outside to deliver 100 extra units at $200. In this case our proposed net income as follows:

      Proposed income statement
Sales   =                   $95,000
(300 250) + (100200)
(-) V. cost           =            $60,000
(400150)                        
Cm                                    $35,000
(-) F. cost           =             $20,000
Net income                       $15,000
 
In this case we will accept the proposal because our proposed net income is greater than the current net income. Though the proposed selling price is less than current one but we can generate more income because in this case fixed cost goes down from (20,000  300) = $66.67 to (20,000  400) = $50.00, So here we see that how fixed cost plays effective role in decision-making.


Variable cost:

A variable cost is a cost that varies in total, in direct proportion to changes in the level of activity. The activity can be expressed in many ways, such as units produced, units sold, miles driven, lines of print and so forth. A good example of variable cost is direct material. It is important to note that when we speak of a cost as being variable, we mean the total cost rises and falls as the activity level rises and falls. There are two types of variable cost.

(1) True variable cost: Direct material is a true variable cost because the amount used during a period will vary in direct proportion to the level of production activity.

(2) Step-variable cost: A cost that is obtained only in large chunks and that increases or decreases only in response to fairly wide changes in the activity level is known as step-variable cost. Maintenance cost is an example of step-variable cost.

Role in decision-making

Variable cost plays a great role in decision-making we know that if we increase our production then our variable cost will also increase. So we have to concentrate on reduction of total cost and in this case we must consider fixed cost also. If we increase our production within our capacity, our unit cost of production will decrease. Because as production increase variable cost will also increase but fixed cost per unit will decrease.

Suppose,
Variable cost =  $1                                                                                                                                                                                                                                                                                                                                                                                                             
          Fixed cost     = $10
          Capacity        = 20 unit

    Production        Variable cost          Fixed cost           Total cost
         unit                   per unit                per unit                per unit

           5                          1                           2                          3
          10                         1                           1                          2
          15                         1                          .56                       1.56

Here we see that as production increases total cost per unit decrease because fixed cost per unit continuously decreases. So, in case of reducing total cost we must increase the production level. And as we know variable cost is constant so we must try to reduce the total cost from other sector to generate more profit. Thus variable cost has a significant impact on selling price.   

Variable cost is also used to calculate cm per unit, cm ratio, margin of safety, degree of operating leverage and other this types of important things.