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

break-even-analysis
A break-even analysis is commonly used to determine the point at which a new product or service will become profitable. The analysis is a financial calculation that tells the business how many products it must sell to cover its production costs.  A break-even analysis is a small business accounting process that tells the business what it needs to do to break even or recoup its initial investment. 

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

economies-of-scale
In Economics, Economies of Scale is a theory for which, as companies grow, they gain cost advantages. More precisely, companies manage to benefit from these cost advantages as they grow, due to increased efficiency in production. Thus, as companies scale and increase production, a subsequent decrease in the costs associated with it will help the organization scale further.

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.

Connected Analysis Frameworks

Cynefin Framework

cynefin-framework
The Cynefin Framework gives context to decision making and problem-solving by providing context and guiding an appropriate response. The five domains of the Cynefin Framework comprise obvious, complicated, complex, chaotic domains and disorder if a domain has not been determined at all.

SWOT Analysis

swot-analysis
A SWOT Analysis is a framework used for evaluating the business’s Strengths, Weaknesses, Opportunities, and Threats. It can aid in identifying the problematic areas of your business so that you can maximize your opportunities. It will also alert you to the challenges your organization might face in the future.

Personal SWOT Analysis

personal-swot-analysis
The SWOT analysis is commonly used as a strategic planning tool in business. However, it is also well suited for personal use in addressing a specific goal or problem. A personal SWOT analysis helps individuals identify their strengths, weaknesses, opportunities, and threats.

Pareto Analysis

pareto-principle-pareto-analysis
The Pareto Analysis is a statistical analysis used in business decision making that identifies a certain number of input factors that have the greatest impact on income. It is based on the similarly named Pareto Principle, which states that 80% of the effect of something can be attributed to just 20% of the drivers.

Failure Mode And Effects Analysis

failure-mode-and-effects-analysis
A failure mode and effects analysis (FMEA) is a structured approach to identifying design failures in a product or process. Developed in the 1950s, the failure mode and effects analysis is one the earliest methodologies of its kind. It enables organizations to anticipate a range of potential failures during the design stage.

Blindspot Analysis

blindspot-analysis
A Blindspot Analysis is a means of unearthing incorrect or outdated assumptions that can harm decision making in an organization. The term “blindspot analysis” was first coined by American economist Michael Porter. Porter argued that in business, outdated ideas or strategies had the potential to stifle modern ideas and prevent them from succeeding. Furthermore, decisions a business thought were made with care caused projects to fail because major factors had not been duly considered.

Comparable Company 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.

Cost-Benefit Analysis

cost-benefit-analysis
A cost-benefit analysis is a process a business can use to analyze decisions according to the costs associated with making that decision. For a cost analysis to be effective it’s important to articulate the project in the simplest terms possible, identify the costs, determine the benefits of project implementation, assess the alternatives.

Agile Business Analysis

agile-business-analysis
Agile Business Analysis (AgileBA) is certification in the form of guidance and training for business analysts seeking to work in agile environments. To support this shift, AgileBA also helps the business analyst relate Agile projects to a wider organizational mission or strategy. To ensure that analysts have the necessary skills and expertise, AgileBA certification was developed.

SOAR Analysis

soar-analysis
A SOAR analysis is a technique that helps businesses at a strategic planning level to: Focus on what they are doing right. Determine which skills could be enhanced. Understand the desires and motivations of their stakeholders.

STEEPLE Analysis

steeple-analysis
The STEEPLE analysis is a variation of the STEEP analysis. Where the step analysis comprises socio-cultural, technological, economic, environmental/ecological, and political factors as the base of the analysis. The STEEPLE analysis adds other two factors such as Legal and Ethical.

Pestel Analysis

pestel-analysis
The PESTEL analysis is a framework that can help marketers assess whether macro-economic factors are affecting an organization. This is a critical step that helps organizations identify potential threats and weaknesses that can be used in other frameworks such as SWOT or to gain a broader and better understanding of the overall marketing environment.

DESTEP Analysis

destep-analysis
A DESTEP analysis is a framework used by businesses to understand their external environment and the issues which may impact them. The DESTEP analysis is an extension of the popular PEST analysis created by Harvard Business School professor Francis J. Aguilar. The DESTEP analysis groups external factors into six categories: demographic, economic, socio-cultural, technological, ecological, and political.

Paired Comparison Analysis

paired-comparison-analysis
A paired comparison analysis is used to rate or rank options where evaluation criteria are subjective by nature. The analysis is particularly useful when there is a lack of clear priorities or objective data to base decisions on. A paired comparison analysis evaluates a range of options by comparing them against each other.

Related Strategy Concepts: Go-To-Market StrategyMarketing StrategyBusiness ModelsTech Business ModelsJobs-To-Be DoneDesign ThinkingLean Startup CanvasValue ChainValue Proposition CanvasBalanced ScorecardBusiness Model CanvasSWOT AnalysisGrowth HackingBundlingUnbundlingBootstrappingVenture CapitalPorter’s Five ForcesPorter’s Generic StrategiesPorter’s Five ForcesPESTEL AnalysisSWOTPorter’s Diamond ModelAnsoffTechnology Adoption CurveTOWSSOARBalanced ScorecardOKRAgile MethodologyValue PropositionVTDF FrameworkBCG MatrixGE McKinsey MatrixKotter’s 8-Step Change Model.

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