Variable vs. Fixed Costs: What’s the Difference?

All businesses incur costs to operate, and understanding how these costs behave is an aspect of financial management. The process of categorizing expenses provides a clear view of where money is being spent, which informs strategic planning and financial forecasting. By sorting expenses based on their reaction to changes in business activity, a company can build a more accurate financial model for budgeting and pricing strategies.

Defining Fixed Costs

A fixed cost is an expense that does not change in total, regardless of the volume of goods or services a company produces or sells. These costs are often time-based, such as monthly or annual expenses, and must be paid even if the company experiences a period of low or zero sales activity. Because these expenses are predictable, they form a stable foundation for budgeting and financial planning.

A common example of a fixed cost is the monthly rent for an office or manufacturing facility. Whether a company produces 100 units or 10,000 units, the lease payment remains the same. Another example is the annual salary for administrative staff. Insurance premiums for property or liability coverage are also fixed, as are property taxes, which do not fluctuate with the company’s output.

Defining Variable Costs

Variable costs are expenses that change in direct proportion to a company’s production or sales volume. When production increases, total variable costs rise, and when production decreases, they fall. The core characteristic of a variable cost is its consistency on a per-unit basis. This relationship between cost and activity is used in analyzing profitability at different levels of output.

The most direct example of a variable cost is raw materials. If a bakery spends $1 on flour, sugar, and eggs for each loaf of bread, the total raw material cost for 100 loaves will be $100. Direct labor paid on a piece-rate basis also represents a variable cost. Sales commissions are another example, as they are a percentage of sales revenue. Shipping and packaging costs also fluctuate directly with the number of products sold and delivered.

Exploring Mixed and Step Costs

Not all expenses fit neatly into the fixed or variable categories. A mixed cost, sometimes called a semi-variable cost, contains both fixed and variable components. A portion of the cost is incurred regardless of activity level, while the other part fluctuates with volume. This means the total cost will change with activity but not in direct proportion to it.

A common example of a mixed cost is a utility bill, which often includes a fixed monthly service fee plus a variable charge based on consumption. A salesperson’s compensation might also be a mixed cost, consisting of a fixed monthly salary plus a commission. Step costs are fixed for a specific range of activity and then increase to a new fixed level once a threshold is surpassed. For instance, a factory may need one supervisor for up to 10,000 units per month, but producing more requires hiring a second supervisor, causing the total salary cost to jump to a new, higher fixed amount.

Calculating Key Business Metrics

Understanding cost behavior allows a business to calculate important performance metrics. These calculations transform the concepts of fixed and variable costs into concrete tools for decision-making, such as setting prices and establishing sales targets.

One useful calculation is the contribution margin, which is the revenue left over to cover fixed costs after variable costs have been subtracted. The formula is Sales Revenue minus Total Variable Costs. This can also be calculated on a per-unit basis by subtracting the variable cost per unit from the selling price per unit. The resulting figure shows how much money each sale contributes toward paying fixed expenses and generating a profit.

This per-unit figure is used to determine the break-even point, which is the level of sales at which total revenues equal total costs, resulting in zero profit and zero loss. To find the break-even point in units, the formula is Total Fixed Costs divided by the Contribution Margin per Unit. This calculation reveals the minimum number of units a company must sell to cover all its expenses.

Consider a t-shirt business with total fixed costs of $10,000 per month. Each t-shirt sells for $25, and the variable costs per shirt are $15. The contribution margin per unit is $10 ($25 selling price – $15 variable costs). To find the break-even point, the business would divide its fixed costs by the contribution margin: $10,000 / $10 = 1,000 units. This means the company must sell 1,000 t-shirts each month to cover its costs.