variable-costs-vs-fixed-costs

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.

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 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.

Companion Frameworks to Cost Structure Analysis

Comparable Analysis

comparable-company-analysis
A comparable company analysis is a process that enables the identification of similar organizations to be used as a comparison to understand the business and financial performance of the target company. To find comparables you can look at two key profiles: the business and financial profile. From the comparable company analysis it is possible to understand the competitive landscape of the target organization.

Business Analysis

business-analysis
Business analysis is a research discipline that helps driving change within an organization by identifying the key elements and processes that drive value. Business analysis can also be used in Identifying new business opportunities or how to take advantage of existing business opportunities to grow your business in the marketplace.

Capital Structure

capital-structure
The capital structure shows how an organization financed its operations. Following the balance sheet structure, usually, assets of an organization can be built either by using equity or liability. Equity usually comprises endowment from shareholders and profit reserves. Where instead, liabilities can comprise either current (short-term debt) or non-current (long-term obligations).

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