Why can the distinction between fixed costs and variable costs be made in the short run?

Question

Classify the following as fixed or variable costs: advertising expenditures, fuel, interest on company-issued bonds, shipping charges, payments for raw materials, real estate taxes, executive salaries, insurance premiums , wage payments, sales taxes, and rental payments on leased office machinery.

Answer 1

The distinction can be made because there are some costs that do not vary with total output. These are the fixed costs that, fundamentally, are related to the scale or size of the plant. In the short run, by definition, the scale of the plant cannot change: The firm cannot bring in more machinery or move to a larger building. All costs that are related to the scale of the plant—costs that continue to be incurred even though the firm’s output may be zero—are fixed costs. On the other hand, the firm can increase its output by using its plant—its fixed capital—more intensively, that is, by hiring more labor, or by using more materials. But by doing so, it will increase its operating costs, its variable costs.

Advertising expenditures: variable costs (although it may be reasonable to argue a fixed component). Fuel: variable costs. Interest on company-issued bonds: fixed costs. Shipping charges: variable costs. Payments for raw materials: variable costs. Real estate taxes: fixed costs. Executive salaries: fixed costs. Insurance premiums: fixed costs. Wage payments: variable costs. Depreciation and obsolescence charges: fixed costs. Sales taxes: variable costs. Rental payments on leased office machinery: fixed costs (although it is possible that short-term lease arrangements on some types of office equipment may rise or fall with output).

In the long run, the firm can, by definition, get out of paying all of its short-run fixed costs; its lease is up, it can fire its executives without penalty, the insurance has run out, and so on. All of its costs at this moment, then, are variable. It can decide to continue producing at the same scale and thus reassume all its previous fixed costs for the next short-run period; or it can decide to increase its scale and thus increase its fixed costs; or it can decide to go out of business and thus have no costs at all.

Answer 2

You have to pay the fixed costs regardless of what your sales levels are........that's why you don't take them into account when you look at a new project.

Variable costs fluctuate based on sales.