Fixed Cost vs Variable Cost: Key Differences Explained

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Fixed and variable costs categorise business expenses into static and fluctuating during changing sales volumes and production outputs. While fixed costs remain the same, variable expenses decrease or increase depending on the business revenue and activity. Understanding the difference between fixed cost and variable cost is essential, as it helps calculate the monthly budget, set product prices, or make important decisions regarding the business’s expense structure and profitability.

In the following sections, we will explain the difference between fixed cost and variable cost, along with their examples.

What Are Fixed Costs?

Fixed costs are time-linked business expenses a company must pay to stay in the business. They do not evolve over time, as they form a company's base costs for day-to-day operations. Since these expenses are unrelated to a company's business activities, they significantly impact its profitability.

Fixed costs may be direct or indirect. Direct costs are linked with the company's design, production, and sale of products, such as a fixed-term commercial lease. Indirect costs, such as energy bills. Some common examples of fixed costs in a company's balance sheet include the following:

Rent: Most companies have a fixed monthly rent for a predetermined term. Even if the rent changes after the term’s end, it becomes a new fixed cost for another term.
Insurance: Insurance is essential to cover a company’s assets or property. Its premiums remain fixed for the entire term.
Staff Salaries: A company must pay salaries to its staff, irrespective of its business performance and profitability.

What Are Variable Costs?

Variable costs are fixed for any business based on the number of goods it produces and sells. These costs decrease or increase with the production volume. When the production goes up, the variable expenses increase. However, if the volume decreases, these expenses follow suit. Companies often stop a production line that becomes outdated or underperforming. Therefore, most of the time, these costs are avoidable. Some common examples of variable costs include the following:

Utility Bills: Electricity, gas, and oil bills fluctuate each month. The more energy the business consumes, the higher the bills are. For instance, if the production increases, the company will consume more electricity to run the manufacturing machines. Hence, it is a variable cost on the company’s balance sheet.
Labour: Employment costs vary with time. If a company hires more employees during peak times, its labour costs rise.
Raw Materials: The prices of raw materials change according to supply and demand. Economic conditions also impact the cost of raw materials. As a company produces more during peak seasons, it will need more raw materials and spend more on them.
Commissions: If a company pays sales commissions, the amount may vary based on the sales it makes. So, it is a variable cost for the business.

What are the Differences Between Fixed and Variable Costs?

The table below summarises the difference between fixed cost and variable cost:

Parameter	Fixed Costs	Variable Costs
Definition	Costs that remain constant for a period regardless of changes in the production output	Costs that change with changes in business activities, sales volume, or production output
Other Names	Overhead costs, supplementary costs, or period costs	Prime costs, direct costs
Nature	Time-related for extended periods	Volume-related, as they change with fluctuating output levels
Frequency	Always necessary irrespective of sales volume and production output	Usually payable when sales volume or production output increases
Examples	Rent, insurance, staff salaries	Utility bills, labour costs, commissions, raw materials

Impact of Fixed and Variable Costs on Business Strategy

Business owners must understand fixed costs and variable costs, as they help them to budget effectively, cost jobs, set prices, and strategise their future business growth. It helps them identify a profitable price level by performing a break-even analysis.

Use this formula to calculate the break-even point:

Break-Even Point = Fixed Costs / (Revenue – Variable Costs)

Apart from providing information about pricing, it also helps a business owner determine their projected profits when planning a business purchase. They can calculate the number of units required for profit, based on which they can decide if the numbers are realistic.

Understanding fixed and variable costs can help a business owner identify expenses that directly impact profitability. By analysing the relative proportions of fixed and variable costs, businesses can make informed decisions about pricing, production levels, and cost-cutting measures.

How to Manage Fixed and Variable Costs Effectively

Here are a few ways to manage fixed cost and variable cost for a business:

A company may adjust the variable costs by reducing waste in the production cycle. Although these costs increase or decrease with products, they are not linked with the production costs. For instance, eliminating the waste increases production with fewer labour, energy, and raw material requirements.
Fixed expenses are harder to reduce, as they are linked to the assets or items necessary for production. However, a company may manage fixed expenses by downsizing into a smaller space or reducing its workforce. The company may also explore fixed costs that it no longer needs or can combine with other items.
The company owners must carefully watch variable expenses, especially when planning business fluctuations or seasonal changes. It gives enough time to secure a Business Loan to cover the increasing costs.

Conclusion

Understanding the fixed cost and variable cost difference is essential for effective business operations. Thoroughly understanding fixed and variable costs helps control them to ensure the profitability and growth of the business. Those who need financial support may borrow a Business Loan to cover the costs and ensure effective management.