When running a business, there are two types of costs: fixed costs and variable costs. Any alteration in the fixed or variable costs may affect your company’s net income and breakeven point. Fixed costs do not shift with the amount of the items produced or sold; however, variable costs do.
Unlike variable costs, fixed costs must be paid regardless of the volume of production. In other words, they are independent of costs associated with business activities and thus cannot be avoided. Fixed costs are the same month-to-month.
There are standard fixed costs that all companies share regardless of their niche and volume, for instance:
Depreciation is the decrease of the fair value of an asset. For example, factory owners will have to depreciate the value of factory equipment every year based on use and natural wear and tear. Typically, a physical asset gradually depreciates through the years until its value reaches $0. Depreciation can be thought of as the opposite as amortization, which is also a fixed cost.
All businesses — no matter what industry — need business insurance, as it helps pay the expenses related to property damage and liability claims. If a business does not have active insurance, owners will have to pay out of pocket for damages and legal claims. Liability insurance is “fixed” in the sense that a business will need it no matter their activities. However, the cost of liability insurance will vary based on your premiums and additional coverage. Liability insurance can also increase over time.
Whether you have an office building, a factory, or a storage unit, all of these spaces cost rent, which typically remains unchanged over your lease term.
This includes typical utility expenses like electricity, water, and specific utilities unique to a company’s industry or niche. Utilities are considered part fixed and part variable. The utilities bill may vary month-to-month depending on lease agreements or if energy usage fluctuates. However, regardless of cost or business production volume, utilities will need to be paid.
You can reduce a few fixed costs to refine your cash flow in several ways. Two comparatively drastic ways to reduce fixed costs are moving to a less expensive workplace and downsizing. A simpler way to reduce your fixed costs would be to find a cheaper wholesale retailer that sells the raw materials your company uses.
Happy Paws Pet Store needs to pay rent for the space to operate the store. It also needs to pay for utilities like cellular reception, internet, and electricity. The owner will also need to pay two employees to run the store. The employees work the same number of hours per week at an hourly rate. The business owner did not have the initial funding needed to open their pet store and took out a loan. As per their loan agreement, they must pay back the borrowed amount in monthly payments. To maintain a pet grooming license, the owner has to pay an annual fee. In this scenario, the fixed costs are:
With the rise of Covid-19 over the past year, many people chose to let go of their office jobs for freelance or at-home positions. A freelance writer working from home still has expenses and costs to look out for. Their home office is 25% of their apartment space and power usage, making 25% of their rent a business-related fixed cost. Add to that renter’s insurance, the power bill, and cable and internet — all of which are required to operate her home office. Some at-home employees may take out a loan to buy electronics such as computers and external hard drives. In this scenario, the fixed costs are:
After you figure out all of the fixed costs at your business, you can use the fixed cost formula to determine the average amount you are spending on fixed costs for each unit your company produces.
To find your average fixed cost per month, start by adding up all the business’s fixed costs. Then, you will have to determine the number of products produced. Divide the first number by the second.
Fixed Cost Formula: Total Fixed Cost / Number of Units per Month = Average Fixed Cost
| Happy Paws Pet Store Fixed Costs Per Month | Expense Amount |
|---|---|
| Rent | $2,500 |
| Building Utilities | $500 |
| Payroll | $1,500 |
| Business loan | $4,200 |
| Pet grooming license | $25 |
| Total fixed cost | = $8,725 |
The total fixed cost per month at Happy Paws Pet Store is $8,725. In this particular month, the store makes 400 sales. We can plug this into the formula like so:
$8,725 / 400 = ~$21
Therefore, the average fixed cost for that month would be about $21.
| Freelancer Fixed Costs Per Month | Expense Amount |
|---|---|
| Rent and renter’s insurance | $1,000 |
| Utilities | $90 |
| Computer loan | $165 |
| Total fixed cost | =$1,255 |
The freelancer writes 23 articles in the above month. By plugging this into the formula, we get:
$1,255 / 23 = $54.50
The average fixed cost for that month would be $54.50.
Contrary to fixed costs, variable costs are immediately related to the volume of sales or units produced. Therefore, as the sales numbers go up, the variable costs increase accordingly — and vice versa. Variable costs pertain to labor and raw materials since these factors change with sales. Variable costs include:
The materials that are used in each product unit. For instance, the glass used in the production of lightbulbs at a homeware factory is a direct material cost.
The machinery and other tools used to produce the final product.
Many retail companies use a sales commission to incentivize their sales representatives to sell more units. This directly plays into the variable cost, as the sales per month for each agent may fluctuate.
Retail companies must pay a certain fee to offer credit cards as a payment option to their customers.
Businesses can calculate their total variable cost by multiplying the total cost to make one unit by the number of products made.
Variable cost formula: Total Variable Cost = Production Volume x Cost Per Unit
For example, if it costs $50 to make one unit and a factory has produced 20 units throughout the month, then the total variable cost for that month is $50 x 20, or $1,000.
Variable costs and fixed costs are the two main types of expenses that a business sustains throughout its operation. Variable costs shift with the number of units produced or sales made, and fixed costs tend to be stable regardless. Variable costs are typically easier to decrease because they do not require a business owner to make drastic changes to their operation, whereas fixed costs do.
For example, a lightbulb factory owner who wants to lower their variable costs may need to look for a cheaper glass source. To lower fixed costs like rent and payroll, they would need to move to another location or fire some employees. For that reason, it’s typically much easier to lower variable costs. Fixed costs may be unavoidable, in some cases, or require major long-term changes.
While they are fundamentally different, variable and fixed costs are equally important. You need to understand both to set a good pricing policy and see your options for growth. If you have any trouble figuring out how to calculate your numbers, you may benefit from reaching out to an accountant for help.
