Variable costs vs. fixed costs

Variable costs are business expenses that fluctuate in response to increases or decreases in production volume.

Conversely, fixed costs remain constant with increases or decreases in production volume.

Aspect	Variable Costs	Fixed Costs
Definition	Variable costs are expenses that change in direct proportion to the level of production or sales. These costs vary as production or sales volumes fluctuate.	Fixed costs are expenses that remain constant regardless of production or sales volumes. They do not fluctuate with changes in business activity.
Nature	Variable costs are dynamic and responsive to business activity, rising as production or sales increase and falling with decreased activity.	Fixed costs are constant, independent of business activity, and do not change with fluctuations in production or sales.
Examples	Examples of variable costs include raw materials, direct labor, sales commissions, shipping costs, and utility expenses that vary with usage.	Examples of fixed costs include rent or lease payments, salaries of permanent employees, insurance premiums, and depreciation expenses.
Behavior	Variable costs exhibit a linear relationship with production or sales, meaning they increase or decrease proportionally with output or revenue.	Fixed costs do not vary with production levels, so they remain the same even if production or sales increase or decrease.
Flexibility	Variable costs offer flexibility as they can be adjusted based on business needs and can be managed to align with revenue generation.	Fixed costs are less flexible, as they must be paid even when the business is not generating significant revenue or production.
Cost Control	Variable costs can be managed effectively to control expenses by optimizing processes, negotiating better supplier deals, or adjusting production levels.	Fixed costs are more challenging to control, as they remain constant, and reducing them often requires structural changes or long-term planning.
Break-Even Point	Variable costs are a crucial component of calculating the break-even point, as they determine the level of sales or production needed to cover all costs.	Fixed costs are part of the break-even analysis but do not change with changes in business activity.
Risk Management	Variability in variable costs allows businesses to adapt to changing market conditions, but it can also expose them to higher expenses during peak periods.	Fixed costs provide stability but can become burdensome during periods of low revenue, posing a risk to profitability.
Short-Term vs. Long-Term Impact	Variable costs primarily impact short-term profitability, making them more manageable in the short run.	Fixed costs have a long-term impact on the financial health of a business, as they persist even if the business experiences short-term setbacks.
Decision-Making	Variable costs are closely monitored in day-to-day decision-making, as adjustments can be made quickly to align with changing circumstances.	Fixed costs are typically considered in long-term strategic planning, as they are less amenable to short-term adjustments.
Cost Structure	Businesses with a higher proportion of variable costs in their cost structure are more adaptable to market changes but may have lower profit margins.	Businesses with a higher proportion of fixed costs tend to have stable profit margins but may struggle in times of reduced revenue.
Industry Variations	Variable cost proportions can vary significantly by industry. Service-based industries often have higher fixed costs, while manufacturing may have higher variable costs.	The proportion of fixed costs in an industry’s cost structure can influence its resilience during economic fluctuations.
Profitability Analysis	Variable costs are integral to calculating gross profit, as they are subtracted from revenue to determine the contribution margin.	Fixed costs are factored into net profit calculations and play a role in determining a company’s overall profitability.
Scale and Growth	As businesses grow, variable costs tend to increase proportionally with sales, while fixed costs may remain relatively stable, resulting in economies of scale.	Scaling a business may necessitate higher investments in fixed costs, such as expanding production facilities or hiring additional staff.
Cost Reduction Strategies	Variable costs can be targeted for cost reduction through efficiency improvements, supplier negotiations, or demand forecasting.	Managing fixed costs involves long-term planning, such as renegotiating leases, consolidating facilities, or optimizing staffing levels.

Table of Contents

Understanding variable costs

Variable costs are those that vary in response to fluctuations in production volume or business activity.

When production volume increases, for example, the variable costs increase in turn. When this volume decreases, variable costs decrease in turn.

Some common costs that behave in this way include:

Raw materials.
Production supplies.
Delivery costs.
Commissions.
Piece-rate labor costs, and
Credit card fees.

By their very nature, variable costs can be difficult to manage. Some costs may fluctuate considerably from one week to the next, while others may increase or decrease without warning.

In either case, variable costs may have more of a direct and immediate impact on profit than fixed costs.

Understanding fixed costs

Fixed costs are those that are independent of output volume or business activity. For this reason, they tend to relate to time-based rather than quantity-based expenses.

Since fixed costs need to be met irrespective of how much product or service is sold, caution must be exercised when a business adds more of them to its operations. This is particularly true of smaller businesses.

Examples include:

Employee salaries.
Insurance coverage.
Loan repayments.
Advertising costs.
Depreciation.
Rent or lease of office space or equipment, and
Utility bills, such as power, water, or gas.

Why do variable and fixed costs matter?

Understanding the differences between variable and fixed costs is essential in determining how to correctly price goods and services in the market.

Awareness of how these costs fluctuate in response to different output levels is also important in crafting an effective business strategy.

Break-even analysis

Both fixed and variable costs are used in break-even analyses to compare various product pricing strategies with respect to the break-even point (BEP).

This is the point at which the sales volume of a product or service enables the business to recoup the costs associated with offering that product or service.

Operating leverage

While the formula is beyond the scope of this article, the relationship between a company’s fixed and variable costs can also be quantified by operating leverage.

Operating leverage is a measure of the extent to which revenue growth translates into operational income growth.

Businesses with high operating leverage can make more money from each sale because they don’t have to increase costs to produce more sales.

As a result, their operating income is considered less risky or volatile.

Businesses with low operating leverage, on the other hand, have more variable costs in relation to fixed costs.

With most costs variable, the operating income is more risky and volatile.

Economies of scale

We can see from the previous point that companies with high operating leverage are more likely to be able to access economies of scale.

In other words, when the company increases production, it can reduce total expenditure since fixed costs are spread over more units of production.

The most basic example is a retail business that buys an item in bulk. Since bulk orders attract a discount from the wholesaler, the retail business can make more money without an associated increase in cost.

Economies of scale also reduce per-unit variable costs since the expanded scope of production increases the efficiency of the production process itself.

Key Similarities between Variable Costs and Fixed Costs:

Business Expenses: Both variable costs and fixed costs are types of business expenses incurred by a company to produce goods or services.
Cost Management: Both types of costs need to be managed effectively to ensure profitability and operational efficiency.
Impact on Profitability: Both variable costs and fixed costs can impact the company’s profitability and break-even point.
Use in Financial Analysis: Both variable costs and fixed costs are used in financial analysis, such as break-even analysis and operating leverage calculations.

Key Differences between Variable Costs and Fixed Costs:

Fluctuation with Production Volume: The primary difference between variable costs and fixed costs is their behavior in response to changes in production volume. Variable costs fluctuate in direct proportion to changes in production volume, while fixed costs remain constant regardless of production volume.
Nature of Expenses: Variable costs are generally tied to the level of activity or production, such as raw materials, commissions, and production supplies. In contrast, fixed costs are time-based and do not vary with production, such as rent, salaries, and insurance.
Predictability: Fixed costs are more predictable and stable over time, as they do not change with production fluctuations. Variable costs, on the other hand, can be more unpredictable and can vary significantly from one period to another.
Management Complexity: Variable costs can be more complex to manage due to their fluctuating nature, while fixed costs are more straightforward to plan and budget.

Use in Financial Analysis:

Break-even Analysis: Both variable costs and fixed costs are used in break-even analysis to determine the point at which a company’s total revenue equals its total costs, resulting in zero profit. This analysis helps in pricing decisions and understanding the minimum sales volume needed to cover costs.
Operating Leverage: The relationship between fixed costs and variable costs is quantified by operating leverage. Companies with high operating leverage have a higher proportion of fixed costs, which can lead to higher profits with increased sales volume.
Economies of Scale: Economies of scale occur when a company’s average cost of production decreases as it produces more goods or services. This reduction in per-unit cost is often influenced by the presence of both fixed and variable costs in the production process.

Key takeaways

Variable costs are business expenses that fluctuate in response to increases or decreases in production volume. Conversely, fixed costs remain constant with increases or decreases in production volume.
Since fixed costs need to be met irrespective of how much product or service is sold, caution must be exercised as a business adds them to its operations. By their very nature, variable costs are more unpredictable and can be difficult to manage.
Understanding fixed and variable costs and the ways in which they interact has important implications in business. Both are crucial to break-even analyses, economies of scale, and operating leverage.