Fixed vs Variable Costs: How They Impact Your Business

Every dollar spent by your business falls into one of two categories: fixed or variable. It’s important to understand the difference because it will help you better plan your budget and growth. Just about every business has both fixed and variable costs, but they function in different ways, especially as your business grows and changes.

The way a business manages its costs is its cost structure. When you understand how your expenses interact with your production volume, you can better forecast, set prices, manage risk effectively, and determine your business’s break-even point — when your business begins to turn a profit. To do that, you need to master the distinction between fixed and variable costs.

What Are Fixed Costs?

Fixed costs are the costs that remain constant in total, regardless of the volume of goods or services your business produces or sells in an operating period. Think of them as unavoidable overhead required to keep your doors open.

Fixed costs must be paid even if your business sells nothing. Unlike variable costs, they don’t change month-to-month based on your sales or performance. For instance, your office rent is the same whether you sign one client or 100.

Examples of fixed costs include:

• Rent or mortgage payments for office/store space.
• Salaries of administrative staff or management (non-production labor).
• Insurance premiums (liability, property).
• Depreciation of equipment.
• Subscription fees for essential software (like a CRM).

These costs tend to be much easier to plan and budget for than variable expenses.

What Are Variable Costs?

Variable costs are expenses that change directly and proportionally with the volume of production or sales. Generally speaking, when you produce more units, your variable costs increase. If you produce less, they decrease. These costs are directly incurred in making your goods or delivering your services, and they will change based on sales and performance.

Some key examples of variable costs include:

• Raw materials (like coffee beans for a roaster, paper for a printer).
• Direct labor (wages paid for the time spent making the product).
• Packaging and shipping materials.
• Sales commissions or transactional fees.
• Utilities tied directly to production (like the cost of electricity for a factory).

Variable costs are harder to plan, but it’s essential to understand how yours work so that you can better strategize your growth.

Mixed Costs and The Relevant Range

Not all costs fit neatly into fixed or variable. Mixed costs (sometimes called semi-variable costs) contain both a fixed component and a variable component. The fixed portion covers the basic service or availability, while the variable part changes based on usage. For instance, a sales team might have a fixed base salary, but their monthly pay varies based on a commission. You can budget for the minimum fixed costs, but you can only estimate the variable cost because you don’t know how each sales rep will perform in a given month.

To properly understand fixed, variable, and mixed costs, you need to use a tool known as the relevant range. The relevant range is the production volume over which cost assumptions remain true. Fixed costs only stay fixed within this range.

For example, if you rent a warehouse that can hold up to 10,000 units of sneakers, you pay a fixed monthly rent within the relevant range of 10,000 units. However, if your sales explode and you have to get a bigger warehouse, your fixed rent cost will likely increase. That exceeds your relevant range. Using relevant ranges is crucial for financial forecasting because it allows you to adapt quickly in the event that something changes in your operations that has a significant impact on your costs.

Why It’s Important to Distinguish

Understanding fixed vs. variable costs isn’t just for your accounting team. It’s crucial for any small business owner or decision-maker because it has a direct impact on your financial forecasting and business strategy. These are some of the key aspects of your business that fixed and variable costs will impact:

Break-Even Analysis

The main reason to separate costs is to help you calculate your break-even point. This is the point at which your total revenue exactly equals your total fixed and variable costs, resulting in a net zero profit. Obviously, the point of any business is to make money, so knowing your break-even point will let you know the minimum sales volume you need to avoid losing money. Pretty important!

The formula to calculate break-even point is:

Break-even point = Fixed costs / contribution margin (CM)

Your contribution margin is the revenue remaining from a sale after all variable costs have been subtracted. It’s the margin that “contributes” to covering fixed costs. So, breaking that formula down further:

Break-even point = Fixed costs / (selling price per unit – variable cost per unit)

For example, let’s go back to that sneaker business. Here’s a step-by-step example to calculate break-even point:

1. Identify your fixed costs: Your monthly overhead expenses are $10,000 for rent, utilities, and base salaries.
2. Determine variable costs: A pair (unit) of sneakers costs $20 to make.
3. Set sales price: You sell your sneakers for $40.
4. Calculate the contribution margin: $40-$20 = $20 per pair of sneakers.
5. Calculate break-even: The break-even point is $10,000 / $20 = 500 units.

You have to sell 500 pairs of sneakers each month to break even.

Pricing Strategy

When you know your break-even point, you know the sales volume you need to hit to reach a profit. But the volume will change depending on your pricing strategy.

It’s not so simple as “higher price, hit break-even faster” because a higher price point may lead to fewer purchases. Likewise, a lower price point that leads to more purchases will require a greater sales volume to break even. It’s a bit of a see-saw.

This is why it’s so important to understand fixed and variable costs. Your fixed costs are the target you want to cover by your total contribution margin. Your variable cost per unit should be the absolute minimum price floor. If you charge less than your variable cost, you’ll lose money on every single item you sell, making it impossible to cover your fixed costs. You can adjust pricing based off of your break-even point to raise your earning potential.

Operating Leverage and Scaling

Understanding your cost mix defines your operating leverage, which is how sensitive your operating income is to changes in sales volume. High fixed costs create high operating leverage, while high variable costs create low operating leverage.

When you have high operating leverage, you need high sales volume to be profitable. The startup period can be risky because the fixed costs are so high, but once you pass the break-even point, every new sales contributes a larger percentage of revenue toward profit.

When you have low operating leverage, your business is better equipped to navigate slow periods because most of your costs decline alongside sales volume. It’s easier to reach the break-even point, but your profit margins grows slower because a larger portion of each new sale is eaten up by variable costs.