Fixed vs Variable Costs: Understanding the Difference

Fixed vs Variable Costs: Understanding the Difference

Launching your startup is no small task, so congratulations on taking the step.

Getting your startup to be financially stable will take time and planning. On average, a guesser/new business US,000 – 40,000 alone in the first year of IT operations. This may be a surprising amount, but the truth is that the nature of costs is that there are always more of them than you think.

It can and often is overwhelming for founders to absorb all of a sudden. So rather than being confused by this, we at FinModelsLabs want to provide you with a good understanding of the basics of costing. In particular the two main categories: fixed and variable costs.

This will help you understand not only the impact on your business, but also what it means for your financial forecasting and budgeting.

We’ll go through the definitions of fixed and variable costs, along with some examples for each type. You will also learn how fixed and variable expenses impact your company’s financial reports and projections.

What is the difference between fixed and variable costs?

Fixed costs and variable costs are distinguished by the nature of their expenses. As the name suggests, fixed costs are fixed: they recur, whether on a weekly, monthly, quarterly, or yearly basis, and do not fluctuate with the performance of your business.

A good example of a fixed cost is your rent. Let’s say for office space, but we can also show server hosting. Whether your business grows quickly or more sluggishly, does not affect whether your owner/hosting company asks you to pay the same amount.

Variable costs, as the name suggests, can vary and change. Some expenses go up and/or down based on business performance, especially sales.

For example, the cost of making your products will vary depending on how many products you actually sell. If you make and sell Halloween decorations for example, and your peak selling time is the third quarter of the year, that time will have a higher raw material cost. This is due to the higher number of goods sold (hence, a higher seasonal cost of goods sold).

Fixed costs: what are they?

Costs that do not fluctuate with your company’s sales levels and remain stable in frequency and payment schedule are called fixed costs.

Fixed costs, such as rent and salaries, must be paid regardless, even in months when sales/income are poor or non-existent.

Now, it’s probably obvious what the downside of fixed costs is: as aforementioned, even when your sales or production drop, there’s no forgiveness or adjustment when it comes to your fixed costs.

Your fixed cost benefit (yes, there is one!) will take some time to realize. And it has to do with economies of scale. The larger your business becomes, the less your relative cost of the product created will be – your fixed costs, by nature of what they are, will be the same when you produce 10,000 units as when you produce 1,000. The difference between the two will be the income you earn in the old scenario, which will be increased tenfold.

The majority of fixed costs are indirect in nature – i.e. they do not per se relate to the actual production/creation of goods and/or services. Rent, for example, is an indirect fixed cost that does not actually affect your production capabilities.

There are, however, fixed costs that directly impact and directly affect production and operational capabilities, such as wages/salaries. This directly affects how your employees are paid, so it affects both your production, middleman and sales output.

Common examples of fixed costs:

• Taxes (goods, income)
• Wages and Salary
• Interest charges (on loans, borrowings)
• Depreciation and amortization
• Rent/lease payments (on offices, equipment, vehicles, licenses)

Variable costs: what are they?

Variable costs are a different category of expenses, which fluctuate due to the production capacity and sales that your businesses encounter.

So when your revenue due to sales increases, so do your variable costs.

When we refer to variable costs, we are generally talking about the costs that directly relate to the creation/production of goods. For example, the purchase of raw materials and inputs, if you are a business that manufactures physical products for sale, is a variable cost. The price of these commodities themselves changes based on supply, and your amount purchased varies based on how much you sell.

However, other variable costs are indirect on the business – such as utilities. Depending on, for example, how many hours your plant/production facility is running, then your utilities, such as electricity, will increase.

The downside of your variable costs is the same as the upside: there are times when the variable nature will work in your favor and be low; But, most often, because these expenses are directly related to your operations, it will often be when your income increases.

Common examples of variable costs:

• Raw materials
• Public services
• Transaction fees
• Contract salary costs (such as billable staff)
• Shipping and delivery costs

Variable costs will be different depending on the particular industry and space your business is in.

Semi-variable costs: what are they?

So we hedged fixed and we hedged variable.

What if we told you there was a third category?

Yes, believe it! Semi-variable costs are a kind of hybrid between fixed and variable costs, as there is a fixed element and a variable element to expenses.

The way it works is that semi-variable costs (also called semi-fixed or mixed) carry a fixed component up to a certain level of output, after which the expenses take on a variable price structure.

Think, for example, of our online storage accounts. There is a certain charge that cloud computing and storage companies (such as Amazon Web Services) charge for usage, up to a certain amount of usage. Thereafter, after a certain threshold, a variable rate applies.

In a non-numerical sense, factories for example have semi-variable electricity utility costs, in which the company pays a fixed cost per month, regardless of the level of production, which pays a certain amount and level of use. Above this point, the company then pays a floating rate.

Application to financial reports and projections

So, that’s fine, but how do fixed and variable costs fit into your business?

Let’s explore some of the important ways that factoring in fixed and variable costs is valuable and insightful for your business. Because the fact is, assessing your fixed and variable costs has several strong benefits for any founder and management team.

1. Break-even point calculation

Discovering the break-even point of your business is crucial, and crucial to doing so is understanding the relationship of fixed and variable costs to your revenue.

The break-even point is the break-even point where your expenses and income are equal. It’s a turning point, because it’s the inflection point of when you make a loss, to make a profit.

The calculation of the break-even point is derived from the following formula:

Break-even quantity = fixed costs / (sales price per unit – variable cost per unit)

Let’s illustrate this with an example.

If you are selling your product for US/unit; Your variable costs are US/unit and you have total fixed costs of US0,000 plus our formula to find out how big our breakeven quantity is:

Breakeven quantity = 0,000 / ( – ) = 15,000 units

So our break-even quantity is 15,000 units. In other words, this is how much we need to produce, selling at per unit, and assuming our variable costs are per unit.

This is a key point for you as a leader to remember. Above this point, you earn money; Below, you lose money.

2. Determine the price of the product

Building on the previous reason, another reason why understanding the difference between your fixed and variable expenses is important is because of the effect it has on how you will value your products and/or services.

In our previous example, you have variable costs of just US/product. Looking at this stat alone, one would think – oh, US/product is a reasonable price because it’s 2 times our variable cost.

However, it is important to keep the break-even formula in mind. The fixed cost of US0,000 and the variable cost per unit of US are natural drags on our profitability. So while US might be twice the variable cost, even at US/product we would need to produce 15,000 units to break.

If we were selling at US per unit, we would only need 7,500 units to break – half of what the previous example calculated.

Things to think about.

3. Source of funding from investors

For any founder or entrepreneur looking to source funding from investors, knowing your expense costs like the back of your hand is a necessity.

Investors will look at your revenue forecast, your sales projections, but they’ll also want to see face-to-face that you have a handle and understanding of your expenses, and if you’ve completed a break-even analysis.

A thorough understanding of your spending profile, including what your fixed VS variable breakdown is.

For a bigger walkthrough and detailed explanation of the different types of investor rounds, take a look at our guide here.

4. Economies of scale

The last point of interest is that the difference in fixed and variable expenses is what we have discussed as rising costs to fixed costs: economies of scale.

Economies of scale is a concept that expenditure per unit tends to decrease, as consumption increases.

One way this manifests is through rebates given by vendors. The cost per unit decreases as production increases, when you have fixed expenses.

For example, as a business, you might be able to buy 20,000 units of a given input to a product at a cheaper rate per unit than you would if the order size was 10,000. units.

This is because your fixed costs stay fixed no matter how your production changes. And as your production increases, your fixed cost per unit decreases.

Let’s assume that your fixed costs are US0,000 per month.

If you only produce 5,000 units in a month, your fixed cost per unit is US; However, if you produce 15,000 units in a month, your fixed cost per unit is US. So your fixed costs stay the same, but your product number has tripled, so your profit per unit also triples.

In conclusion, it is very important to understand fixed and variable expenses, both their differences and how they jointly affect your business. From break-even analysis to break-even, there’s a lot to learn and gain by going all out on your spend profile.