Every business decision depends on a deep understanding of the costs. And one of the main costs are called “Fixed” and “Variable”. Knowing the difference between these two isn’t just a matter of accounting—it’s the secret to smart budgeting, strategic planning, and maximizing profits. In this article, we’ll uncover the essential differences between these two types of costs, and explore how they impact businesses. Let’s dive into the world of variable and fixed costs and unlock the keys to financial success. Mastering them can propel your company to new heights.
What are Variable costs?
Variable costs are expenses that fluctuate in direct proportion to the level of production or sales activity. In other words, these costs vary based on the volume of goods or services a business produces. When production increases, variable costs rise; conversely, when production decreases, variable costs fall.
Variable costs can be defined by amount or percentage. On one hand Amount variable fee refers to the specific cost associated with producing one additional unit. For instance, if producing one more cake in a bakery costs $27 in ingredients, packaging, and labor, this $27 is a variable cost by amount.
On the other hand variable costs can also be expressed as a percentage of sales revenue. For example, if a bakery spends 30% of its sales revenue on ingredients, packaging, and labor, this percentage represents the variable cost by percentage.
Common examples of variable costs include:
- Raw Materials: The cost of raw materials needed to produce goods will vary depending on the quantity produced.
- Direct Labor: Wages paid to workers directly involved in the production process, such as assembly line workers, can vary with the level of output.
- Commissions: Sales commissions paid to employees based on the number of units sold or revenue generated.
- Packaging Costs: Expenses for packaging materials that increase with the number of units produced.
Variable costs practical example
The key characteristic of variable costs is their direct correlation with production volume. This makes them relatively easy to adjust in response to changes in business activity. Imagine running a small bakery that specializes in custom cakes. For each sold cake, you incur the following variable costs:
- Ingredients (flour, sugar, eggs, etc.): $15 per cake
- Packaging: $2 per cake
- Direct Labor (baker’s time): $10 per cake
Let’s say you produce and sell 100 cakes in a month. Here’s how the variable costs add up:
- Ingredients: 100 cakes x $15 = $1,500
- Packaging: 100 cakes x $2 = $200
- Direct Labor: 100 cakes x $10 = $1,000
Total Variable Costs for 100 cakes = $1,500 + $200 + $1,000 = $2,700.
If you produce and sell 200 cakes instead, the variable costs would be:
- Ingredients: 200 cakes x $15 = $3,000
- Packaging: 200 cakes x $2 = $400
- Direct Labor: 200 cakes x $10 = $2,000
Total Variable Costs for 200 cakes = $3,000 + $400 + $2,000 = $5,400
As seen on the example, the sales doubled while the production costs also doubled. Variable costs correlate with the number of pieces sold.
What are fixed costs?
Fixed costs, on the other hand, are expenses that remain constant regardless of the level of production or sales activity. These costs are incurred even if a business produces nothing. Fixed costs are typically associated with the basic operational functions of a business, and include expenses such as:
- Rent or Lease Payments: Payments for office or manufacturing space remain constant regardless of production levels.
- Salaries: Wages paid to administrative and management staff who are not directly involved in production.
- Depreciation: The systematic allocation of the cost of tangible assets like machinery and equipment over their useful lives.
- Insurance: Premiums for various types of business insurance, which do not vary with production levels.
Fixed costs practical example
Continuing with the bakery example, consider these fixed costs that do not change regardless of how many cakes you produce:
- Rent for bakery space: $1,200 per month
- Salaries for administrative staff: $2,000 per month
- Insurance: $300 per month
- Depreciation of baking equipment: $500 per month
Total Fixed Costs = $1,200 + $2,000 + $300 + $500 = $4,000 per month
The most important information is that, whether you bake 100 cakes, 200 cakes, or no cakes at all, your total fixed costs remain the same at $4,000 per month.
Variable and fixed costs can be also mixed
It is worth noting that some costs exhibit characteristics of both variable and fixed costs, known as mixed or semi-variable costs. An example can be a credit card payment fee, this payment method can combine a fixed base charge (For example $0,1) + a variable charge based on amount paid (for example 2 %). Businesses need to separate these components for accurate financial analysis.
How can difference between fixed and variable cost help business?
Understanding the difference between variable and fixed costs is essential for several aspects of business management.
Budgeting and Forecasting
Accurate budgeting requires distinguishing between fixed and variable costs to predict expenses accurately. Fixed costs provide a baseline, while variable costs allow for adjustments based on anticipated production levels.
Cost-Volume-Profit Analysis
This analysis helps determine the break-even point—the level of sales at which total revenues equal total costs. By understanding fixed and variable costs, businesses can better assess how changes in sales volume impact profitability.
Pricing Strategies
Knowing the nature of costs aids in setting prices that cover both fixed and variable costs while ensuring a profit margin. For instance, businesses can price products to cover variable costs and contribute to fixed costs.
Decision-Making
In decision-making scenarios such as expanding production or entering new markets, understanding fixed and variable costs helps evaluate the potential financial impact and feasibility.
Conclusion
Understanding the difference between variable and fixed costs is essential for accurate budgeting, strategic planning, and overall financial health. Variable costs fluctuate with production volume and can be defined by both amount and percentage of sales, while fixed costs remain constant regardless of production levels. By mastering these concepts, businesses can make informed decisions that drive profitability and growth.