Before using these terms, “variable” and “fixed” costs need to be defined.
A variable cost is an expense that varies with revenue or the size of sales. Many people referred to the vocabulary definition of variable and think it means that it is an expense that varies with time. This is untrue. In the financial world, a variable expense varies with revenue or volume.
A fixed expense is an expense that does not vary with revenue or volume. For every expense, you ask and answer a simple question: “If I produce and sell one more kWh do I spend more money on this expense?” If the answer is yes, then it is a variable expense. If the answer is no, then it is a fixed expense.
Fuel costs are driven not only by the cost of the fuel that is being transformed to electricity, but also by the efficiency of the translation process. Fuel costs are truly variable costs. That is, these costs vary directly with the kilowatt-hours (kWh) generated by the plant. When more electricity is generated, more fuel is consumed.
O&M costs, on the other hand, are not generally considered to be variable costs. The plant staff earns a base wage plus benefits that are fixed. Overtime for increased production is an extremely small input to variable costs; so small that it is usually overlooked. Similarly, routine and overhaul maintenance are considered fixed costs. Incremental plant operation, unless much more than typical, does not alter the usual maintenance routine and intervals. Finally, many costs associated with the plant, like insurance and property taxes, are fixed and change only with variables outside the plant. Both of these costs generally increase yearly with the inflation rate.
Cycling a plant from full output to lower output levels causes an increase in wear and tear on the plant components. Although the money spent on labor and material to operate and maintain the plant does not change at the time the cycling occurs, the increase in wear and tear can increase the frequency of future maintenance, thus causing an increase in average O&M costs. Therefore, O&M costs do not usually increase with each new kWh generated by the plant.
Although this seems like a minor point, it is financially crucial that individuals making short-term pricing and running decisions for the plant understand this concept. The financial implication is that increasing the plant output by 10 percent when it is already running does not increase the plant’s O&M costs significantly. Therefore, the generation company can maximize profit by accepting a lower price for the incremental kWh that the plant generates as long as the price the company receives covers the plant’s increase in variable costs, which in this case would be the plant’s increase in fuel costs and pollution credit costs. In fact, a large portion of the incremental revenue that the generation company realizes from the 10 percent increase in plant output will be added right to profit if the plant’s incremental fuel cost and pollution credit costs per kWh are small in comparison to the incremental market price the company charges for the additional kWh.
A company experiences capital costs (namely depreciation and financing costs for plant construction) with the passage of time. Whether the plant produces one kWh or a million kWhs has no effect on the amount of depreciation and interest costs the plant incurs. Therefore, capital costs are also fixed costs. So, fuel costs are variable costs, while O&M costs and capital costs are fixed costs.
