Understanding Variable vs. Fixed Costs: A Guide for Small Business Owners
Running a successful business requires more than just a great product or service—you need to understand your numbers and control costs. One critical component of this understanding is differentiating between variable costs and fixed costs.
This guide explains the difference between fixed and variable costs, provides examples of each, and covers how to use this knowledge to reach your business goals.
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What Are Variable Costs?
In financial accounting, variable costs are expenses that fluctuate with your business's level of sales or production volume. Simply put, the more you produce or sell, the higher these costs become.
Here are a few examples of variable costs:
Raw materials. If you manufacture a product, the materials required will increase as production scales.
Direct labor. Wages paid to workers based on hours worked or units produced.
Shipping costs. The more products you sell, the higher your shipping expenses.
Credit card fees. These are typically a percentage of sales, so they rise with higher revenue.
Sales commissions. Incentives paid to your sales team for selling your products and services vary depending on sales volumes.
Income and sales taxes. The taxes you pay on your income or sales fluctuate based on sales and profits.
Equipment and machine repairs. Maintenance costs for your equipment and machinery tend to rise when production increases.
Credit card transaction fees. The more transactions you process each month, the higher the fees you pay to payment processing platforms.
Variable costs directly impact your profit margins. As your business grows, monitoring these costs ensures your profits grow proportionally. For example, if raw material costs increase unexpectedly, your profit margins might shrink unless you increase your price.
What Are Fixed Costs?
Fixed costs remain constant regardless of your production or sales volume. Whether you produce ten units or 10,000 units, these expenses stay the same.
Some common examples of fixed costs include:
Rent or lease payments. The monthly rent you pay for your office, warehouse, retail, or factory space.
Loan payments. Monthly payments of principal and interest on fixed interest rate loans.
Salaried employees. Staff paid a fixed amount regardless of how many hours they work.
Insurance premiums. Monthly or yearly payments for business insurance, professional liability, health insurance, and other necessary policies.
Utilities. Basic services like electricity, water, and internet (though some costs might have variable components, such as electricity for manufacturing).
Fixed costs are a significant factor in determining your break-even point—the sales level at which your total revenue equals total costs. Understanding these costs allows you to set realistic pricing and sales goals.
Why You Need to Understand Fixed and Variable Costs
Understanding your fixed and variable costs offers several benefits for your business. Here are some of the ways you can use this information.
Pricing strategy. Knowing your costs helps you set prices that cover expenses and deliver profits. For example, understanding the variable cost per unit ensures you price above that threshold while accounting for fixed costs.
Break-even analysis. Fixed costs are a crucial element in calculating your break-even point. For example, if your fixed costs are $10,000 per month and your profit per unit sold is $20, you’d need to sell at least 500 units to cover your costs.
Budgeting and forecasting. Predicting how costs will change as your business grows allows you to plan effectively. If you anticipate doubling your sales next year, you can calculate the corresponding increase in variable costs.
Cost control. By categorizing expenses as fixed or variable, companies can identify areas to cut back. For example, renegotiating supplier contracts could reduce your variable costs, while exploring remote work options might lower fixed costs like office rent and utilities.
Profit margins. A clear understanding of your cost structure helps maintain or improve profit margins. If variable costs rise due to supply chain issues, you’ll know when to adjust your pricing or explore alternatives to reach your financial goals.
Fixed and Variable Costs in Action
Let's look at an example of fixed and variable expenses to see how they work in the real world.
Imagine you own a small bakery. Your fixed costs include $2,000 monthly rent and $1,000 for equipment leasing. Your variable costs include $0.50 for ingredients per cupcake and $0.30 for packaging. If you sell a cupcake for $3, your profit per cupcake before fixed costs is $2.20.
To calculate your break-even point:
Fixed costs = $3,000 (rent + lease).
Profit per cupcake = $2.20.
Break-even point = Fixed costs ÷ Profit per unit = $3,000 ÷ $2.20 ≈ 1,364 cupcakes.
This means you need to sell at least 1,364 cupcakes monthly to cover your costs. Each additional unit sold is profit.
Tips for Managing Fixed and Variable Costs
No matter how successful your business is, it's essential to control costs.
According to SCORE.org, cash flow problems are the number one reason small businesses fail, so keeping a tight rein on your expenses lets you prioritize spending and build cash reserves for leaner times.
Controlling variable and fixed costs also allows you to free up money to allocate for better purposes, such as creating new products or services or expanding into new markets.
Here are ways to manage your fixed and variable expenses:
Monitor costs regularly. Keep a close eye on cost trends to identify issues early. Variable costs can spike unexpectedly due to external factors like supply chain disruptions.
Negotiate contracts. Renegotiate fixed-cost agreements like leases or insurance premiums to find savings.
Use technology. Implement software to track expenses and identify cost-saving opportunities. Many accounting software platforms categorize expenses and compare budget to actual results.
Review pricing regularly. Periodically reassess pricing to ensure it reflects current variable costs and market conditions.
Get Help Making Smarter Decisions with Cost Insights
Understanding your fixed and variable costs is foundational for effective financial management. It allows you to set competitive prices, forecast profits, and make informed decisions about scaling your business.
If you’re looking to dive deeper into your business’s cost structure or need professional guidance, contact Slate today. We'd love to help you analyze your expenses, optimize your pricing strategy, and unlock your business’s full potential. Let’s build a smarter, more profitable future for your business together.