Variable costs vs. fixed costs: Learn the differences through real-life examples

In the business world, if you don’t understand where your money is flowing, you’re at a high risk of failure. This article helps you “see clearly” how fixed costs and variable costs work and how to manage them effectively.

Business Cost Equation: Total Cost = Fixed Cost + Variable Cost

These two costs are like two sides of the same coin. Fixed costs are expenses that occur regardless of whether the business makes sales or not. Variable costs increase or decrease with the volume of production or sales. A deep understanding of the differences between these two types will help you set appropriate prices, manage cash flow, and accurately determine your break-even point.

Variable Cost (Variable Cost): Costs that “dance with the business”

Variable costs are expenses that rise or fall depending on the quantity you produce or sell. The more you sell, the higher these costs; the less you sell, the lower they become.

###Characteristics of Variable Costs

• Not fixed: Change directly in proportion to production or sales volume
• Flexible: You can reduce these costs when sales decline
• Easy to control: Improving efficiency will immediately impact these costs

###Common Examples of Variable Costs in Business

Raw materials and components: If you produce shirts, the amount of fabric used depends on the number of shirts made. The more shirts, the more fabric needed.

Direct wages: Workers paid based on actual work done. More work means higher wages; less work means lower wages.

Energy and utilities: The more electricity and water used during production, the higher the costs. High production levels = high electricity bills.

Packaging and shipping: The more products, the more boxes and transportation costs.

Commissions: Sales teams earning a percentage of sales. Higher sales mean higher commissions.

Managing variable costs skillfully can significantly increase profits by reducing per-unit production costs or negotiating better prices with suppliers.

Fixed Cost (Fixed Cost): Costs that “follow you everywhere”

Fixed costs are expenses that the business must pay regardless of sales or production levels. Common fixed costs in modern businesses include:

###Normal Characteristics of Fixed Costs

• Unchanging: Remain the same whether you sell or produce or not
• Mandatory payments: Must be paid even if the business halts production for a day
• Difficult to adjust: Reducing fixed costs requires time and contractual arrangements

###Examples of Fixed Costs That Challenge Entrepreneurs

Rent for premises and buildings: Whether you sell or not, rent payments are due monthly.

Salaries: Regular employees receive fixed monthly wages, regardless of profit or loss.

Insurance: Business, asset, liability insurance premiums are paid regularly as per contracts.

Depreciation of equipment and machinery: Expensive equipment depreciates annually.

Loan interest: Borrowed funds accrue interest that must be paid whether the business succeeds or not.

Licenses and operational fees: Permits, approvals, and licenses incur annual costs.

These fixed costs require careful planning and appropriate contractual arrangements to ensure the business can bear the burden.

Comparing Fixed and Variable Costs: Different Approaches to Calculation

Clearly distinguishing these two types of costs is essential because each impacts business decision-making differently.

Fixed Cost (Fixed Cost)

• Result from long-term agreements (Lease contracts, employment agreements, etc.)
• No flexibility; must be paid in full every month
• Risk planning possible (because the amount is known in advance)
• When sales decline, these costs become a heavy burden
• Examples: Rent, salaries, insurance, depreciation, interest

Variable Cost (Variable Cost)

• Arise from daily operations (Raw materials, daily wages, etc.)
• Highly flexible; can be reduced when production decreases
• Difficult to predict (due to market prices, volume, etc.)
• Production improvements can immediately lower these costs
• Examples: Raw materials, wages, energy, packaging, commissions

Break-even Point and Cost Analysis

When you combine fixed and variable costs, you get total cost, which allows you to calculate the (Break-even Point).

Break-even point is where sales revenue equals total costs. You neither profit nor lose.

Finding this point helps you understand how much you need to sell to sustain the business and when you start making a profit.

###Benefits of Cost Mix Analysis

Pricing: You need to know total costs to set a price that covers costs and yields profit.

Production planning: Understanding how variable costs behave helps plan optimal production quantities.

Investment decisions: Before investing in new equipment (which increases fixed costs), calculate how much you can save on variable costs.

Cost control: This analysis reveals which costs are too high and where to cut costs.

Impact assessment: When market conditions change or sales increase, you’ll understand how profits are affected.

Serious Cost Management Strategies

For Fixed Costs:

• Negotiate lower rent; consider alternative landlords
• Decide whether to sign long-term or short-term leases
• Hire carefully; avoid unnecessary staffing
• Review insurance policies; switching providers may reduce costs

For Variable Costs:

• Negotiate prices with suppliers; avoid always ordering on credit
• Improve production efficiency; reduce waste and defective products
• Use technology to lower energy consumption
• Find ways to reduce transportation and logistics costs

Summary: Why is this important?

All businesses are different, but managing fixed and variable costs is fundamental to good business management. Understanding the differences provides a solid foundation for making strategic decisions.

Fixed costs that are predictable help you know your monthly expenses, while flexible variable costs allow you to adapt quickly to changing production levels.

Successful entrepreneurs often know which costs to cut quickly to maintain profits and which to invest in to increase business value. This knowledge helps you compete and grow sustainably over the long term.