Knowing the difference between expenses and revenue is the key to understanding the profitability of your business. As fixed and variable costs make up the cost structure of your business, understanding the fluctuation of expenses and how they tie into your sales volume can help you make sound business decisions that will ultimately drive profits.
- Businesses incur two types of costs: fixed costs and variable costs.
- Fixed costs remain the same throughout a specific period.
- Variable costs can increase or decrease based on the output of the business.
- Examples of fixed costs include rent, taxes, and insurance.
- Examples of variable costs include credit card fees, direct labor, and commission.
What Are Fixed and Variable Costs?
Fixed costs and variable costs are two main types of costs a business can incur when producing goods and services. Businesses use fixed costs for expenses that remain constant for a specific period, such as rent or loan payments, while variable costs are for expenses that change constantly, such as taxes, labor, and operational expenses.
Fixed costs are generally easier to plan, manage, and budget for than variable costs. However, as a business owner, it is crucial to monitor and understand how both fixed and variable costs impact your business as they determine the price level of your goods and services.
Businesses can have semi-variable costs, which include a combination of fixed and variable costs. An example of a semi-variable cost is a vehicle rental that is billed at a base rate plus a per-mile charge.
Fixed Costs vs. Variable Costs
|Fixed Cost||Variable Cost|
|Remains constant for a specific period regardless of the output or volume of business activities||Changes in proportion to the output or volume of business activities|
|Also known as overhead, indirect, or supplementary costs||Also known as direct costs or prime costs|
|Fixed costs are time-related||Variable costs are volume-related|
|Examples include rent, insurance premiums, depreciation, and property taxes||Examples include credit card fees, direct labor, commission, and part-time wages|
Fixed Costs Explained
Fixed costs refer to predetermined expenses that will remain the same for a specific period and are not influenced by how the business is performing. Since most businesses will have certain fixed costs regardless of whether there is any business activity, they are easier to budget for as they stay the same throughout the financial year.
A good way of determining what your fixed costs are is to think about the costs your business would incur if you had to temporarily close. As an example, you would still have to pay rent and insurance, which would be considered fixed costs.
Other examples of fixed costs include:
- Telephone and internet costs
- Loan payments
Variable Costs Explained
Variable costs, however, do not remain the same and are usually directly linked to business activities. These are based on the volume of goods or services produced and the business’s performance.
Examples of variable expenses include:
- Direct labor
- Operational expenses
Variable costs can be challenging to manage as they can vary from month to month, increase or decrease quickly, and have a more direct impact on profit than fixed costs.
A business can also have discretionary expenses such as gifts, vacations, and entertainment costs. These are desirable, but you can choose whether to have them or not.
Why the Differences Between Fixed and Variable Costs Matter
When it comes to fixed and variable costs, a clear understanding of each is essential for identifying the correct price level for goods and services. Understanding how costs can change with fluctuations in volume and output levels can help refine your overall business strategy.
Economies of Scale
Understanding the difference between fixed and variable costs can help a business owner identify economies of scale, which occur when a business makes cost reductions as it increases its level of production. By achieving economies of scale, a business can spread out fixed costs over a larger number of products or services and decrease variable costs in the process, resulting in significant cost advantages.
Fixed and variable costs contribute to the ability of a business owner to get a clear picture of the cost structure of the business, which is why it’s important to understand the differences between these two cost types.
Making informed decisions about business expenses can help drive profitability.
A business uses break-even analysis to determine when it will be able to cover all of its expenses and begin to make a profit. For example, a business may use this analysis to determine the number of products that need to be sold to cover its cost of production. Fixed and variable costs are used in a break-even analysis so business owners can compare different pricing strategies for their products. You can use this formula when calculating a break-even point:
Variable expenses used in this analysis can include the raw materials or inventory involved in the production, whereas the fixed costs can include rent for the production plant.
Operating leverage measures the degree to which a business can increase operating income by increasing revenue. A business that generates sales with a high gross margin and low variable costs has high operating leverage. With a higher operating leverage, a business can generate more profit.
Here is a formula for calculating operating leverage:
Examples of Fixed Costs
Fixed costs typically stay the same for a specific period and they are often time-related. A good example of this is monthly rent payments.
For example, a business rents a building for a fixed cost of $50,000 per month for five years. The rent will stay the same every month, regardless of the business’s profit or losses.
Keep in mind that fixed costs may not be consistent in the long run. In the example above, the rent will stay the same until the business no longer occupies the space, or when the agreement comes to an end and the owner decides to increase the rent for the next rental period.
In another example, let’s say a business has a fixed cost of $7,500 to rent a machine it uses to produce shoes. If the business does not produce any shoes for the month, it still has to pay $7,500 for the cost of renting the machine. Similarly, if the business produces 10,000 mugs, the cost of renting the machine stays the same.
Example of Variable Costs
As variable costs change directly in relation to the output of a business, so when there is no output, there are no variable costs. A good example of variable costs is the operational expenses that increase or decrease based on the business activity. If a business grows, so will its expenses such as utility bills for electricity, gas, or water.
Another example of variable costs would be if a business produces hats at $5 each. If the business produces 200 units, its variable cost would be $1,000. But if the company does not produce any hats, it will not incur any variable costs for the production of the hats. Similarly, if it produces 1,000 hats, the variable cost would rise to $5,000.
How Do You Determine Variable vs. Fixed Costs for a Product?
You can calculate the variable cost for a product by dividing the total variable expenses by the number of units for sale. To determine the fixed cost per unit, divide the total fixed cost by the number of units for sale.
How Do You Separate Fixed Costs From Variable Costs in Semi-variable Costs?
As semi-variable costs consist of both fixed and variable costs, you can separate the two by identifying which costs would remain constant, even with no change in the production output of your business. An example of a semi-variable cost can be the electricity bill for your business. It may cost you $2,000 a month to function at a basic level and keep the lights on, but during a busy month where production increased significantly, your electricity bill for that month could increase to $2,500 or more.
Which Costs More, Fixed or Variable Interest?
In terms of taking out loans, fixed interest rates are generally a better option than variable interest rates if you want to minimize risk. This is because variable rates can fluctuate monthly or quarterly and depend on economic conditions, which may change unexpectedly. By contrast, fixed rates never change for the duration of the loan.
The Bottom Line
From an accounting perspective, fixed and variable costs will impact your financial statements. For instance, you can’t calculate cash flow or pretax income without considering these expenses. As a business owner, understanding fixed and variable expenses as part of your overall business expenses is crucial for developing your long-term financial plans.
Continuously review income statements, balance sheets, and other financial statements to make the necessary adjustments and ensure that you do what’s best for your company at all times.