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The difference between fixed and variable costs
Financial Events
When you are looking at the balance sheet of a potential equity to invest in, it’s important to be clear on the difference between a company’s fixed and variable costs. Businesses of all shapes and sizes have two kinds of cost when they deliver their goods or services – fixed costs and variable costs.
Let's explore the nuances between fixed and variable operating costs for business, along with real-world examples. We’ll also explain the value of distinguishing between fixed costs and variable costs from an investment perspective.
What are fixed costs?
Fixed costs are a type of business expense that a company is contractually obliged to pay. They are usually time-linked, too. A fixed cost is something that does not evolve over time. As they are largely set in stone, fixed costs typically form the ‘base costs’ of a company’s day-to-day operations.
Generally, fixed costs will significantly influence an equity’s overall profitability. That’s because these charges are due irrespective of the company’s business activities, i.e. how many goods or services it sells.
Fixed costs for a business can be considered direct or indirect costs. A direct cost is intrinsically linked to the design, manufacture, or sale of goods or services. This could be a commercial lease on-premises over a fixed term. An indirect cost fluctuates more readily. Using the same commercial lease example, the energy bills to power the company’s premises would be an indirect cost as, although it is used within the premises, it can’t be influenced by the unit.
Examples of fixed costs
A fixed cost stays the same, regardless of whether production output rises or falls. Common examples of a fixed cost within a business’ balance sheet include:
- Commercial rent
Most commercial rents will have a fixed monthly or annual cost for a business, at least during the initial term of the rent agreement. Even when the rent of a lease changes at the end of an initial term, this usually becomes a new fixed cost if the new term is more or less expensive.
- Online advertising
If a company has an online advertising budget of $10,000, this is a fixed cost as the top line figure does not change. The company has ring-fenced $10,000 as a fixed cost to cover its online advertising and will not pay a penny more or less.
- Insurances
The cost of insurance premiums to cover a company’s property or assets is typically a fixed cost. Although sometimes insurances can be variable, such as the cost of worker compensation insurance, which may or may not be needed.
- Depreciation
The depreciation of assets is also a fixed cost. Companies will typically devise a depreciation expense schedule for all their assets, with their values declining over time. Depreciation isn’t a variable cost because the decline in assets isn’t determined by its activity volume.
Are fixed costs considered sunk costs?
In financial accounting terms, sunk costs are all fixed costs – but that doesn’t mean all fixed costs are sunk. Sometimes in the lifespan of a business where a fixed cost isn’t irretrievable. For instance, when a company purchases production machinery for its warehouse, although it is a fixed cost, it is not a sunk cost. That’s because the business can sell on its used machinery to recoup some or all of the initial purchase cost.
A company’s monthly fuel costs – which cover its vehicle fleet – is the prime example of a sunk cost. It’s not possible to reclaim the petrol or diesel used to drive from A to B.
What are variable costs?
The difference between variable costs and fixed costs is that the former is intrinsically linked to the output of the company. Variable costs rise and fall as production increases or decreases. The easiest way for an investor to calculate the variable costs of a business is to multiply the output of a company by the variable cost per unit of its output.
Let’s say Company A manufactures 1,000 vehicles at a cost per unit of $5,000. Its variable cost for total production would be $5m. However, if Company A struggled to source materials or electrical components for new vehicles the following year and only built 400 new vehicles – at a higher cost per unit of $8,000 because of material shortages – its variable cost for total production would be $3.2m.
As you can see, the total variable cost to produce a company’s goods or services will directly influence the bottom line of a business. In fact, the fluctuation of variable costs for a business is one of the main drivers of the rise or fall of its share price. When costs rise – eating into profits – the share price is more likely to fall.
Examples of variable costs
A variable cost is exactly that – variable. It can rise and fall based on a company’s productivity. Common examples include:
- Labour
Employment costs vary from year to year. If a company takes on more employees, its labour costs will rise. Similarly, if a company is forced to grant a pay rise to its staff, its labour costs will also rise. Sometimes an above-inflation pay rise to staff can be a show of fiscal strength from a company.
- Raw materials
The cost-of-living crisis experienced across the UK and beyond right now relates to many raw materials. With trade barriers and supply chain issues increased because of the ongoing crisis in Ukraine and the Covid-19 pandemic, the price of raw materials has risen significantly. This has seen variable costs rise for many manufacturers and producers.
- Commissions
If a company pays a commission on every sale, this will be a variable cost. That’s because the amount a business pays in commission will be linked to the number of sales it makes.
- Utility costs
The fluctuation of gas, electricity and oil has influenced utility charges for businesses. The more energy a business uses, the more it has to pay, hence why it’s a variable cost on the balance sheet.
Is a marginal cost the same as a variable cost?
Variable costs can fall under the umbrella of a marginal cost. Marginal costs relate to business expenses linked to the production of new units of output or the serving of an additional customer. They are incremental costs that increase over time to help produce additional units of output. As part of the outlay for production, variable costs are included as a marginal cost most times.
Understanding total costs
Once you are familiar with fixed and variable costs, you can then take into consideration total costs, which are both of the above costs combined. Total fixed costs will cover all expenses a company is contractually obliged to pay. For argument’s sake, let’s say Company A pays $5,000 per month to let its industrial headquarters, as well as $2,000 a month to hire its production machinery. It also pays $400 a month in insurance. The firm’s total fixed costs would be $7,400 a month.
Let’s say Company A also produces 1,000 smartphones a month for $20 per unit, inclusive of all electrical components that need importing from Asia. It has a staff wage bill of $10,000 per month, too. Its total variable costs would be $30,000 a month.
Ultimately, potential investors need to keep a keen eye on a company’s total costs. Keeping a lid on total overheads is vital to ensure the long-term sustainability and solvency of a business – and publicly listed corporations are no different.
Why it’s important to distinguish between fixed and variable costs
As a prospective investor, being able to establish the difference between a company’s fixed and variable costs can help you make two further key calculations – a business’ break-even point and the identity of economies of scale.
Once you are aware of a company’s fixed and variable costs, it’s possible to determine the price point that a business must hit to maintain profitability. This is achieved by undertaking the break-even analysis formula:
Fixed costs / price – variable costs = volume needed to break even
The formula provides insight into a company’s pricing structure, and it can also provide a picture of how many more units a business would need to sell if its variable costs increased due to ambitious expansion. There’s also an opportunity for prospective investors to make basic forecasts for a company’s projected profits during the current trading year. This is beneficial if it’s a company that regularly pays dividends to shareholders.
Once you have a firm grasp of a company’s fixed and variable outgoings, these figures can also be manipulated to find out their economies of scale. It’s possible to determine the sweet spot of a company’s finances, where increased output meets fixed costs spread across a greater number of items.
Ultimately, by mastering a company’s fixed and variable costs, you can get immediate insight into a firm’s cost structure and make clear, rational decisions based on the likely short and long-term profitability of a business.