How important is it for a business to understand the difference between fixed costs and variable costs?

Making a profit in business is not easy if you don’t understand your own cost structure. Most entrepreneurs tend to think that profit = revenue - costs, but in reality, there are many types of costs, and managing each type requires different strategies.

Distinguishing between variable costs and fixed costs is a fundamental basis for financial analysis that helps businesses to:

• Set reasonable selling prices
• Plan production and find the break-even point
• Control costs and increase profits
• Make correct investment decisions

Fixed Costs: Expenses that are “Obligatory” to Pay

What are fixed costs? These are expenses that occur regardless of how many products you sell or how many services you provide. They are like commitments you must pay every month or year, without change.

Common examples of fixed costs

Rent - Whether you sell 0 or 100,000 units, the rent for your office or factory remains the same, paid in full.

Salaries of regular staff - Full-time employees paid monthly, regardless of whether the month is good or bad for sales.

Insurance - Office insurance, property insurance, liability insurance, all fixed annually.

Depreciation - Machinery, equipment, assets that decrease in value each year.

Loan interest - If you borrow money, you must pay interest every installment, whether the business is thriving or not.

Utilities (Electricity, water) and basic utilities - While some may vary, the minimum base remains fixed.

Characteristics of fixed costs

Fixed costs have clear properties: stable, not subject to risk, and easy to forecast. However, they also impose “pressure” on the business to generate enough sales or services to cover these costs, at least.

Variable Costs: Expenses that are “Flexible” according to Production

What are variable costs? These are expenses that change proportionally with the volume of production or sales. The more you produce or sell, the higher the costs; the less you produce, the lower the costs.

Examples of variable costs in real business operations

Raw materials and production supplies - If you produce shirts, each requires fabric, thread, buttons. More shirts mean more raw materials, increasing costs.

Direct labor - Hourly workers or project-based wages paid according to the amount of work done.

Packaging and shipping - Selling more requires more boxes; shipping costs increase accordingly.

Sales commissions - Sales teams or agents paid based on sales volume.

Electricity and water (Variable parts) - Some utility costs increase with production volume.

Packaging and QC - Quality checks, packing, all increase with volume.

Advantages of understanding variable costs

Because variable costs fluctuate with production, businesses have flexibility in control. If the market is slow, you can reduce production, and variable costs will decrease accordingly. This is about timing and strategic adjustment in business operations.

Clear Comparison: Fixed Costs vs. Variable Costs

Next Step? Total Cost and Break-even Point

Once you understand fixed and variable costs, the next step is calculating Total Cost, which equals Fixed Costs + Variable Costs.

Knowing the total cost helps you to:

Set appropriate selling prices - The per-unit total cost tells you the minimum price to avoid losses.

Find the break-even point - How many units you need to sell so that revenue = total costs (no profit but no loss).

Plan growth - When sales exceed the break-even point, the surplus becomes your profit.

Evaluate cost reduction strategies - You know whether to cut fixed costs or variable costs for maximum benefit.

Cost Management Tips Every Business Should Know

Reduce fixed costs - Consider whether utilities are necessary or if you can work from home to lower fixed costs and reduce risk during downturns.

Control variable costs - Negotiate with suppliers, find cheaper materials, improve production efficiency.

Avoid letting variable costs spiral - If sales are poor, avoid overproducing; variable costs remain high if production continues at full capacity. Make production decisions based on actual demand.

Maintain a big-picture view - Review fixed and variable costs quarterly to identify changes.

Summary: Understanding Costs = Understanding Our Business

The difference between fixed costs (like rent, salaries, interest) and variable costs (like raw materials, wages, shipping) is just one aspect of accounting knowledge, but it is hugely important for business operations.

A business that understands both types of costs and can implement effective cost management strategies will be highly competitive, adaptable to market changes quickly, and financially stable in the long run.

If you’re still confused about calculating your organization’s costs, consider studying Break-even Analysis further, as it will help you see the overall picture of your business more clearly.