Understanding the difference between fixed and variable costs is critical for individuals and businesses alike. Whether you’re managing your household budget or analyzing company expenses, these two types of costs play a significant role in decision-making, cash flow management, and profitability.
In this blog, we’ll break down fixed costs and variable costs, share real-life examples, and help you optimize your spending strategy.
Fixed Costs vs Variable Costs: An Overview
- Fixed Costs: These are expenses that remain constant regardless of production or sales activity.
- Variable Costs: These costs fluctuate based on business activity, production volume, or usage.
Knowing the difference between the two helps businesses predict cash flow, determine pricing strategies, and manage expenses effectively.
What are Fixed Costs?
Fixed costs are expenses that remain unchanged, regardless of how much a business produces or sells. These costs are predictable, making them easier to plan and budget for.
However, since they don’t fluctuate with production levels, they can strain cash flow during slow periods.
Examples of Fixed Costs
Rent or Lease Payments
Imagine a bakery renting a commercial space for $2,000 a month. Whether the barkery produces 10 cakes or 10,000 cakes, the rent remains the same.
Salaries for Permanent Staff
Fixed salaries are paid consistently to full-time employees, regardless of business activity. For instance, the bakery’s manager earns $4,000 every month, whether it’s peak wedding season or a slow winter month.
Loan Payments
Suppose the bakery took a loan to buy an industrial oven, with monthly repayments of $1,500. These payments remain constant whether the oven is used for 100 hours or sits idle.
Depreciation
The cost of fixed assets, such as machinery or vehicles, is spread over time as depreciation. For example, the industrial oven might lose $200 in value every month, irrespective of usage.
How Fixed Costs Impact Cash Flow
Fixed costs remain constant regardless of production or sales volume. While this predictability is useful for budgeting, fixed costs can pressure cash flow during periods of low revenue. Businesses must meet these obligations (e.g., rent, salaries, loan repayments) even if their income drops.
Example
A bakery pays $2,000 in monthly rent for its space, whether it sells 100 cakes or 1,000 cakes. If the bakery earns only $1,500 in revenue during a slow month, it still needs to cover the $2,000 rent, creating a cash flow deficit.
Challenge
Fixed costs are inflexible, meaning businesses cannot immediately reduce them to align with falling revenues.
What are Variable Costs?
Variable costs, on the other hand, are expenses that fluctuate with production levels or business activity. If production increases, variable costs rise proportionately. Conversely, if production decreases or halts, variable costs drop.
Example of Variable Costs
Raw Materials
Let’s say a bakery produces muffins alongside cakes. Each muffin costs $1.50 in raw materials (flour, sugar, butter, etc.).
If the bakery produces 500 muffins, the total raw material cost will be:
500 muffins x $1.50 = $750
Utility Costs
Electricity and gas are critical for running ovens and lights. If the bakery increases production, energy usage rises. Conversely, during downtime, utility costs drop significantly. For example, the bakery might pay $300 for electricity in a busy month and $150 during slower months.
Packaging
Packaging costs scale with production. If each box costs $0.50 and the bakery ships 1,000 cupcakes, packaging costs a total of $500. Fewer orders mean fewer expenses.
Commissions
In businesses with commission-based roles, costs increase with sales. For example, if a salesperson earns a 5% commission on cupcake orders, a $1,000 order costs the bakery $50 in commissions.
No sales? No commission cost.
How Variable Costs Impact Cashflow
Variable costs, on the other hand, fluctuate with business activity or production levels. When production or sales slow down, these costs decrease, providing businesses with greater flexibility to manage cash flow during challenging times.
Example
A bakery spends $1.50 on raw materials (flour, sugar, etc.) for each cupcake it produces. If demand for cupcakes increases and production rises from 200 cupcakes to 400, raw material costs double from $300 to $600. If demand drops and production falls to zero, raw material costs also drop to zero.
A Benefit Here
Variable costs allow businesses to scale expenses with demand. If revenue slows, businesses can immediately reduce these costs to conserve cash.
Balancing Fixed and Variable Costs for Healthy Cash Flow
To maintain healthy cash flow, businesses need to strike a balance between fixed and variable costs:
- Plan for Fixed Costs: Ensure consistent cash reserves to cover fixed obligations during slow periods. Consider negotiating fixed costs like rent or salaries to make them more manageable.
- Monitor Variable Costs: Keep a close eye on expenses that scale with production. Look for ways to optimize processes, reduce waste, and improve cost efficiency.
- Forecast Cash Flow: Historical data to predict periods of high and low revenue, and adjust spending accordingly.
Example Recap
A bakery pays $2,000 monthly rent (fixed cost) and spends $1.50 per cupcake on raw materials (variable cost).
In a month with 100 cupcakes produced, the total costs are:
- Fixed: $2,000 (rent)
- Variable: $150 (100 cupcakes × $1.50)
- Total Cost: $2,150
If production doubles to 200 cupcakes, variable costs rise to $300, making the total cost $2,300.
If the bakery produces nothing, the fixed cost remains $2,000, while variable costs drop to $0.
What are Semi-Variable Costs?
Semi-variable costs have both fixed and variable components. A portion remains constant, while the rest varies based on activity.
Examples of Semi-Variable Costs
- Electricity Bill: A factory pays a fixed base charge plus a variable amount depending on usage.
- Salaries with Overtime: A manager’s base salary remains fixed, but overtime pay increases with additional work hours.
How to Budget for Fixed and Variable Costs
Budgeting for fixed and variable costs is crucial for maintaining financial health and avoiding overspending. Here’s a step-by-step breakdown:
Track Expenses
The first step to budgeting fixed and variable costs is to track and categorize all your business expenses:
Fixed Costs: Rent, salaries, loan payments, and insurance.
Variable Costs: Utilities, raw materials, commissions, and packaging.
Solution: Use an expense management software to automate receipt collection, expense tracking, and coding.
Prioritize Essentials
Fixed costs are non-negotiable, so allocate funds for these first. Once fixed expenses are covered, you can allocate the remaining funds for variable and discretionary spending.
A Simple Example of Budget Allocation
If a business earns $10,000 monthly:
- Fixed Costs (e.g., rent, salaries): $5,000
- Variable Costs (e.g., raw materials, utilities): $3,000
- Savings/Reserves: $1,000
- Miscellaneous/Discretionary: $1,000
Solution: Create a budget that prioritizes fixed obligations to avoid disruptions in operations.
Monitor Variable Costs
Variable costs are flexible, so analyze spending patterns and identify areas to save.
- Look for inefficiencies in energy usage, supplier costs, or production processes.
- Track seasonal changes: Costs like raw materials may spike during high production months.
Use Tools for Expense Management
Expense management tools like Fyle automate expense tracking and budgeting, helping businesses gain real-time visibility into their spending.
- Track expenses by categories, projects, and employees.
- Automate alerts for overspending or policy violations.
Marginal Costs vs Variable Costs
Variable costs are expenses that change proportionally with production volume, while marginal costs refer to the additional cost incurred when producing one more unit of a product.
It helps businesses evaluate whether scaling production is profitable.
Example of Marginal Costs
If producing 100 cakes costs $500, and producing 101 cakes costs $505, the marginal cost for the 101st cake is:
$505 - $500 = $5
How Can Businesses Reduce Variable Expenses?
Reducing variable expenses requires strategic action to optimize operations without compromising quality. Here are some things businesses can do:
- Identify Cost Drivers: Analyze what factors influence variable costs the most—raw materials, energy usage, or labor.
- Optimize Processes: Implement automation to reduce manual work and increase efficiency.
- Negotiate with Vendors: Work with suppliers to secure long-term contracts, bulk discounts, or better payment terms.
- Monitor Usage and Waste: Track resources like energy, raw materials, and supplies to identify areas of waste.
How Fyle Can Help Manage Fixed and Variable Expenses
Managing fixed and variable expenses can be overwhelming without the right tools. Fyle simplifies this process in the following ways:
- Real-Time Credit Card Feeds Fyle directly connects to credit card networks like Visa, Mastercard, and American Express to give you real-time text notifications of all credit card transactions. Employees can reply to this message with a picture of the receipt, and it’s automatically matched to the corresponding card transaction.
- Instant Receipt Collection: Employees can submit receipts via text message, email, Slack, or other every day apps reducing delays.
- Real-Time Spend Visibility: Fyle’s real-time expense dashboard provides a complete view of expenses by categories, projects, departments, or merchants.
- Automated Policy Compliance: Fyle automatically flags policy violations or duplicate expenses for faster approvals.
- Multi-Level Approvals: Set customized approval workflows to ensure expenses align with budgets.
- Seamless Accounting Integrations: Connect Fyle with accounting software like QuickBooks, Xero, and Sage Intacct for effortless expense management.
