Fixed vs. Variable Costs

Running a small business involves navigating expenses, from overheads to operational costs. 

These expenses can be generally sorted into two categories — fixed and variable costs. Whether you operate a home service business, an e-commerce storefront, a retail company, or even a professional services business, understanding your fixed and variable costs is key to great financial health. 

In this article, we explore the nuances of fixed and variable costs to help you understand the difference between the two. We take a look at these costs within the context of small businesses, exploring examples, differences, strategies for reduction, and effective budgeting techniques.

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What is a Fixed Cost?

Fixed costs are expenses that remain constant regardless of your current sales revenue or spending. 

These costs do not vary with the quantity of goods or services produced or sold by a business, making them essential expenditures that must be covered to maintain operations. Fixed costs are incurred regardless of changes in output and typically remain consistent over time.

Examples of fixed costs prevalent across various industries include:

• Rent or Lease Payments: The cost of renting or leasing office space, storefront, warehouse, or manufacturing facility remains constant regardless of fluctuations in business activity. Only at the end of a lease agreement can this cost be increased. 
• Insurance Premiums: Insurance policies covering property, liability, or employee benefits often involve fixed monthly or annual premiums that do not change based on production levels. However, as your sales and business size increase, the annual cost of insurance can rise as well. 
• Employee Salaries: The salaries you pay to permanent employees — such as administrative staff, managers, or support personnel — represent fixed costs for businesses regardless of productivity or sales performance. Unlike hourly employees who can make differing amounts on their paychecks, salaried employees earn a consistent, agreed-upon wage. 
• Utilities: Certain utility expenses, such as internet services, may be considered fixed costs if they remain consistent regardless of usage levels. However, utilities like water and electricity can become variable costs due to inconsistent usage levels, making it highly important to be mindful of your energy and water consumption in business spaces.
• Subscription Fees: Regular subscription fees for essential services or software, such as accounting software, customer relationship management (CRM) systems, or cloud storage, are fixed costs that businesses must budget for regularly. In some cases, a subscription service may offer both a fixed and variable rate for you to choose between. 

Understanding fixed costs is essential for small business owners as they represent ongoing financial commitments that must be met irrespective of business activity levels. By identifying and managing fixed costs, you can establish stable financial foundations, budget effectively, and make informed decisions to ensure the long-term sustainability and success of your business.

What is a Variable Cost?

Variable costs are expenses that fluctuate in direct proportion to factors like sales or energy consumption.

Unlike fixed costs, which remain constant regardless of output, variable costs rise or fall as business activity levels change. Understanding variable costs is essential for small business owners as these costs directly impact the profitability of each unit produced or sold.

Examples of variable costs include:

• Cost of Goods Sold (COGS): The cost of raw materials or inventory required to produce goods is a classic example of a variable cost. As production increases, so does the expenditure on materials needed for manufacturing.
• Direct Labor: Wages or salaries paid to workers directly involved in the production process are variable costs. Hiring additional workers or increasing overtime hours to meet higher demand results in higher labor expenses.
• Utilities: Utility expenses such as electricity, water, or gas can fluctuate based on production levels. Increased usage of equipment or machinery may drive up energy consumption costs and lead to higher utility bills, making these costs variable.
• Packaging and Shipping: For businesses involved in selling physical products, packaging materials, and shipping costs are variable expenses. As sales volumes increase, so do the expenses associated with packaging and delivering goods to customers.
• Commission or Sales Fees: Variable costs also include commission payments to sales representatives or fees associated with sales transactions. As sales volume rises, so does the expenditure on commissions or transaction fees.

It’s important to note that while variable costs change with production or sales volume, certain expenses  may exhibit characteristics of both fixed and variable costs depending on the circumstances. 

For example, labor costs may include both fixed salaries for permanent employees and variable wages for temporary workers hired during peak periods.

By understanding variable costs and their relationship to business activity levels, your business can effectively manage expenses, optimize pricing strategies, and make informed decisions to maximize profitability. Proper budgeting and cost control measures can help small business owners navigate fluctuations in variable costs and maintain financial stability in dynamic market environments.

How Do Fixed and Variable Costs Differ?

Fixed and variable costs are two distinct categories of expenses that businesses incur in their operations, each with unique characteristics and implications for financial management. 

Understanding the differences between fixed and variable costs is essential for small business owners to make informed decisions and manage their finances.

Here’s an overview of the difference between the two: 

Fixed Costs:

• Stability: Fixed costs provide a stable foundation for businesses, as they remain consistent over time and are unaffected by fluctuations in output or sales. These can form the core of your business’s budget, as you know exactly how much you owe versus how much you save when calculating your daily, monthly, or annual expenses. 
• Pre-Determined: Fixed costs are typically pre-determined and contractual in nature, making them predictable expenses that can be budgeted for in advance. For example, a rental or leasing agreement locks you into a set monthly cost for a defined period, typically six months to one year. After that period ends, the cost of rent can be increased or renegotiated. 
• Non-Production Costs: Fixed costs are often not directly tied to the production or sales volume of goods or services. Even if production levels decrease, fixed costs remain unchanged. This is important to consider when pricing products, as you must ensure your sales revenue is sufficient enough to cover your operational expenses. 

Variable Costs:

• Flexibility: Variable costs are flexible and adjust according to changes in business activity levels. As production increases, variable costs rise, and vice versa. This flexibility makes it easier to scale your business up or down according to demand, as you can increase or decrease your day-to-day expenses based on your current needs. 
• Directly Linked to Production: Unlike fixed costs, variable costs are directly linked to the level of production or sales volume. Higher output leads to higher variable costs, while lower output results in reduced variable expenses. Understanding how fluctuations in production impact your variable costs is the key to creating a dynamic and adaptable budget. 
• Limited Control: With variable costs, your business must be mindful of its production activities to ensure costs do not extend beyond your financial means. Variable costs can be managed and controlled to some extent through strategic decisions such as optimizing production processes, negotiating supplier contracts, or adjusting staffing levels.

The key differences between fixed and variable costs lie in their stability, relationship to business activity levels, and controllability. By understanding these distinctions, small business owners can effectively manage both types of costs, optimize financial performance, and make informed financial decisions.

Reducing Variable Costs

Reducing variable costs can significantly impact a small business’s profitability. Here are some strategies to effectively manage and reduce variable costs:

• Supplier Negotiation: Negotiate with suppliers to secure discounts or favorable payment terms for raw materials or inventory. Offering early payments can be a great way to earn better payment terms, as you are providing suppliers with a deal that benefits both of your needs.
• Streamline Operations: Identify and eliminate inefficiencies in production processes to minimize waste and optimize resource utilization.
• Outsourcing: Consider outsourcing non-core activities such as fulfillment or customer service to specialized service providers, potentially reducing labor and overhead costs.
• Technology Integration: Invest in technology solutions that automate repetitive tasks or improve productivity, reducing the need for manual labor and associated costs.
• Lean Inventory Management: Implement just-in-time inventory practices to minimize excess inventory holding costs and storage expenses.

Budgeting for Variable and Fixed Costs

Effective budgeting is essential for managing both fixed and variable costs in a small business. 

Here’s how you can take your budget to the next level:

• Separate Budgets: Create separate budgets for fixed and variable costs to better track and manage expenses. By doing so, you can identify the highest costs in each category and determine whether any changes are needed to improve your financial health. 
• Flexibility: Allow for flexibility in budgeting for variable costs to accommodate fluctuations in sales or production volumes. It’s best to create a high-low budget to account for a full spectrum of potential costs, ensuring you are prepared for any scenario. 
• Contingency Planning: Allocate a portion of the budget for unforeseen expenses or emergencies to safeguard your business’s financial resilience in uncertain times. At the end of the year, you can use any extra savings to help pay taxes, restock inventory, and other crucial EOY tasks. 
• Review & Improve: Review budgets periodically to identify areas of overspending or opportunities for cost savings, making adjustments as necessary. Improve your financial management by utilizing bookkeeping and accounting tools designed for small businesses. 

TL;DR: Fixed Costs are Constant, Variable Costs Fluctuate

While fixed costs remain constant regardless of production or sales volume, variable costs fluctuate with production, sales, and energy consumption. 

Small business owners can reduce variable costs through strategies such as supplier negotiation, streamlining operations, and technology integration. Effective budgeting involves separating fixed and variable costs, allowing for flexibility and contingency planning, and regularly reviewing budgets to identify opportunities for cost savings. 

By understanding and managing fixed and variable costs effectively, entrepreneurs can enhance financial stability and drive business growth.

Get Expert Advice on Managing Your Money from Dialed In Bookkeeping

Dialed In Bookkeeping offers bookkeeping, powerful financial reporting, and advisory services to businesses in the home services industry. Book a free call with Dialed In Bookkeeping today to get started. 

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