Fixed & Variable Costs (Edexcel A-Level Economics 3.3.2)

Fixed Costs

• Expenses that remain constant in the short run; independent of output or sales volume
• Must be paid even when Q = 0 (e.g. during shutdown)
• Also called “overheads”
• High fixed costs ⇒ higher output required to break even
• Common examples:
  • Rent / leasing charges
  • Insurance premiums
  • Salaried staff (fixed portion)
  • Marketing budget commitments
  • Consulting & research fees
  • Depreciation on capital equipment

Variable Costs

• Expenses that rise or fall directly with production or sales volume
• Total variable cost (TVC) increases as Q rises; falls when Q falls
• Average variable cost: AVC = \frac{TVC}{Q}
• Determined by marginal cost of each extra unit
• Typical examples:
  • Raw materials & components
  • Energy / fuel used in production
  • Packaging & shipping
  • Commission-based wages, part-time labour
  • Warranty repair outlays

Cost Curves & Relationships

• Total fixed cost (TFC) curve: horizontal line; e.g. TFC = £500 for all output levels
• Average fixed cost (AFC): AFC = \frac{TFC}{Q} ⇒ falls continuously as output rises
  • Example with TFC = £500
  • Q = 1 → AFC = £500
  • Q = 2 → AFC = £250
  • Q = 5 → AFC = £100
• Because TFC is unchanged, spreading it over more units lowers per-unit cost – key to competitiveness

Strategic Implications for Firms

• Start-ups & challengers aim to scale quickly to reduce AFC and overall average cost
• Lean production strategies: keep fixed costs minimal (e.g. rent equipment, use short-term contracts) to lower break-even output
• Economies of scale (technological improvements, government incentives) can cut both fixed and variable costs, as seen in the heat-pump market