Fixed Costs vs. Variable Costs

What are fixed costs?

Fixed costs are costs that remain constant regardless of how much your company produces or sells. Examples of fixed costs include:

• Rent or mortgage payment
• Property taxes
• Interest payments
• Depreciation of assets
• Insurance
• Salaries

For example, if you own a bakery and have a bad month, you’ll still owe the same amount for your rent or mortgage, your liability insurance, your employees’ salaries, etc. These and other fixed costs don’t change as your business changes. Likewise, your fixed costs will account for a smaller percentage of your total expenses if your bakery increases in popularity and generates more sales.

Because fixed costs are stable in the short term, they’re relatively easy to project and include in your budget. Fixed costs (like everything else) become more difficult to predict as you start looking to the future. One day, growth in your bakery’s neighborhood might cause your rent or property taxes to increase. Or your coverage needs might change, resulting in higher insurance rates. But for now, your fixed costs are predictable, and that’s an advantage.

What are variable costs?

Variable costs are costs that change based on how much your company produces or sells. When production or sales increase, variable costs also increase. When production or sales decrease, variable costs follow suit. Some examples of variable costs are:

• Cost of goods sold (COGS)
• Raw materials
• Packaging
• Hourly wages
• Sales commissions
• Transaction fees

Sticking with the bakery scenario, if your business picks up during the holiday season, you’ll need to buy more flour, sugar, eggs, butter, and packaging materials. You might even need to hire part-time, seasonal employees to help you meet the demand. If business increases substantially, you’ll find that your variable costs increase alongside your profits.

The opposite, of course, is also true. If there’s a downturn in business after the holidays, for example, you won’t bring in as much profit. But you also won’t be spending as much money on ingredients, packaging, or seasonal employees.

Comparing fixed and variable costs

Every business, no matter its size, incurs both fixed and variable costs. But cost structure differs greatly from industry to industry. If you’re a graphic designer who works from a home office, your fixed costs will be very different from those of a restaurant owner or a furniture manufacturer.

Taking into account your fixed costs (easy to predict) and your variable costs (not so easy to predict) can give you important information about the health of your business. Your ability to plan for growth or handle a downturn is fundamental to your continued success.

Let’s compare the fixed and variable costs of a few different businesses.

A graphic designer working from home

The fixed costs of rent, utilities, insurance, and security associated with commercial space are among the reasons many startup businesses operate out of a home office. A graphic designer can “open shop” for the cost of a computer, web hosting, and the necessary software. They can set up in a spare room (or corner) of their home, and they can meet with clients on the phone, online, or even in person at a nearby coffee shop.

Running a company out of their home can dramatically reduce their fixed costs, allowing them to be more profitable. The relative lack of space may limit the amount of business they can conduct long term, but it’s a viable option if they’re just starting out or plan to remain a small operation.

Variable costs for a graphic designer working from home may include new software, office supplies, advertising fees, business cards and official letterhead, transportation, additional courses to help hone their skills, and travel to conferences.

A restaurant owner

A restaurant owner will need a brick-and-mortar space in order to do business, so rent and insurance will be among their most notable fixed costs. Even if they opt for a delivery-only model, they still have to prepare food in a commercial kitchen that meets all health and safety standards. A traditional restaurant will also need seating space, furniture, and access to parking or public transportation. Location will be a major factor in what type of clientele the restaurant can attract and how expensive the rent will be.

Variable costs for a restaurant owner include food, beverages, paper goods, wages for non-salaried employees, uniforms, and janitorial services. All of these costs will rise with an increase in business and contract when things are slower.

A furniture manufacturer

A manufacturing firm—like a high-end furniture maker, for instance—will also have substantial fixed costs. They’ll need commercial space, both for fabrication and storage. Large equipment and tools used to create the pieces may depreciate over time. They might need vehicles like forklifts to move raw materials in and out of the factory space, and the business might invest in its own trucks to deliver the goods.

Variable costs for a furniture maker could include raw materials, wages, packaging, and gas for delivery trucks. These costs will increase as production ramps up during certain times of the year.

Apples and oranges

Fixed costs can be similar across industries: A restaurant and a furniture shop both need a lot of space and specialized equipment. But it’s rarely useful to compare the variable costs of 2 companies in different industries. Looking at the variable costs of 2 restaurants would make much more sense than comparing the ingredients necessary to make a pizza and the raw materials needed to make a dining room set.

But both fixed and variable costs differ dramatically when looking at a small, one-person service business that can be operated entirely online versus a business that requires physical space and multiple people to help run it.

Evaluating costs

Your cost structure—essentially, your ratio of fixed to variable costs—is a key element in the resilience of your business. Proper distribution of fixed versus variable costs is fundamental to being able to survive the tough times and capitalize on opportunities.

Generally speaking, companies with a higher percentage of variable costs will have an easier time persevering through an economic downturn. Because you can’t lower your fixed costs (at least, not without taking dramatic steps), decreased variable costs will lower your overall expenses.

Think of the Great Recession and COVID-19. Businesses with high fixed costs were more likely to have to make difficult decisions about continuing to pay rent and salaries. Businesses with a greater percentage of variable costs were able to decrease their output and still cover their fixed costs.

Break-even analysis

Understanding your fixed and variable costs can help you evaluate how much you should charge or how much product you need to sell in order to turn a profit. A break-even analysis is an easy way of doing this. Here’s the formula:

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Volume needed to break even = Fixed costs / (Price per unit - Variable costs per unit output)

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For a bakery that makes specialty cakes, the break-even analysis might look something like this:

Volume = The number of cakes that need to be sold to break even for the year = ?

Fixed costs = Annual rent, insurance, equipment depreciation, and salaries = $100,000

Price per unit = The amount the bakery charges for one cake = $75

Variable costs per unit output = The cost of ingredients and labor to make one cake = $22

1,886.79 = $100,000 / ($75 - $22)

Over the course of a year, the bakery would need to sell 1,887 cakes—about 36 cakes per week—to break even. Anything more than that would allow the company to be profitable.

The variable costs could change in the short term, of course. A labor shortage could mean that the bakery owner has to pay its bakers more per hour. Ingredient costs could change as well—an unfavorable year for wheat could raise the cost of flour. The owner should find, however, that their fixed costs remain relatively stable.

Economies of scale

You know that increasing sales will boost your profits. But it’s also important to understand that increasing production can also help you lower your costs, resulting in even greater profits. So in keeping with our bakery example, as sales steadily rise, each cake will eventually cost less to produce. There are 2 reasons for this.

1. Total fixed costs remain constant and spread over a larger number of units, thus per-unit fixed costs decrease. The lease on your bakery will not increase just because your business is booming. Nor will your insurance or salaries.
2. As output increases, per-unit variable costs usually decrease. If your specialty cake sales are booming, you can buy ingredients in bulk from your suppliers and negotiate lower per-unit costs.

Understanding your costs

Understanding your organization’s cost structure is key to running a profitable business. Taking a deeper look at where you’re spending money will help you identify areas where you can cut costs, thereby increasing your profits.

By closely tracking all your business expenses and classifying them as fixed or variable costs, you’ll have a better handle on the health of your business.

Make sure that you’re taking advantage of the right tools and the right professionals along the way. For instance, if you’re more of an entrepreneur and less of an accountant, consider hiring a bookkeeper or CPA. to help out with the financial side.

It’s also a good idea to use record-keeping software that helps you track expenses and your income. This will keep you on top of your day-to-day finances and help you get a better idea of your overall financial outlook.

Once you’ve identified your fixed and variable costs and understand how they affect your profitability, you can begin to plan for future growth—and develop contingency plans to handle a rough patch. Running a business involves taking risks, but by understanding your finances, you can set yourself on the path to success.