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The difference between fixed and variable costs
Financial Events
Key takeaways:
- Fixed and variable costs show how a company’s expenses respond to output, sales volume or usage, which can help investors assess profitability and resilience.
- Fixed costs, such as some rent, insurance or depreciation, usually remain broadly stable over a relevant period but may still change over time.
- Variable costs, such as raw materials, sales commissions or usage-based utilities, rise or fall with production levels, sales activity or resource use.
- Sunk costs and marginal costs are separate concepts; sunk costs are already incurred and irrecoverable, while marginal cost is the cost of producing one more unit.
- Understanding fixed and variable costs can support break-even analysis and help assess economies of scale, margins and how cost structures affect business performance.
When reviewing a company as a potential equity investment, it is useful to understand how its costs behave. Many operating costs can be analysed as fixed, variable, or partly fixed and partly variable, depending on how they respond to output or sales volume.
Let's explore the nuances between fixed and variable operating costs, 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 expenses that do not vary directly with output over the relevant period (for example, certain rent or salaried staff costs). They may still change over time (e.g., on renewal or as contracts change). Because they are relatively stable over the relevant period, fixed costs typically form part of a company’s base operating costs.
Fixed costs can significantly influence a company’s profitability because they are due regardless of the company’s business activity, including how many goods or services it sells.
Fixed and variable costs should not be confused with direct and indirect costs. Direct costs can be traced to a specific product, service or project, while indirect costs are overheads that support the business more broadly. Either type can be fixed or variable depending on the business model. For example, factory rent may be a fixed overhead, while electricity may include both fixed standing charges and usage-based variable costs.
Examples of fixed costs
A fixed cost usually stays broadly stable over the relevant period, regardless of whether production output rises or falls.
Common examples 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
Advertising spending is often discretionary and may vary with strategy, campaign performance or sales targets. However, a fixed monthly media budget or contracted agency fee can be treated as a fixed cost for budgeting purposes.
- Insurances
Premiums for property or asset insurance are often treated as fixed costs during the policy period. Some insurance costs, such as workers’ compensation premiums, may vary with payroll, claims experience or local rules.
- Depreciation
Depreciation is a non-cash accounting expense that is often treated as a fixed operating expense for analysis, but it depends on the asset base and accounting policies, and some methods (e.g., units-of-production) can link depreciation to output.
Are fixed costs considered sunk costs?
In financial accounting terms, sunk costs are costs already incurred that cannot be recovered. They can be fixed or variable, and not all fixed costs are sunk. For example, if a company buys production machinery, the purchase is a capital expenditure rather than an operating cost, and the asset may later be sold to recover part of its value. Depreciation related to that machinery may be treated as a fixed cost in analysis, but the original asset is not necessarily a fully sunk cost.
Fuel already consumed is sunk (irrecoverable), but fuel expense is usually a variable operating cost linked to usage. It’s not possible to reclaim the petrol or diesel used to drive from A to B.
What are variable costs?
Variable costs are expenses that rise or fall with production volume, sales volume or usage. In a simple model, total variable cost can be estimated by multiplying output by the variable cost per unit.
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, changes in variable costs can affect margins and profitability, which may influence investor expectations and share price alongside many other factors.
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
Some labour costs are variable, such as hourly wages, overtime or temporary staffing linked to production levels. Other labour costs, such as salaries for permanent staff, may be more fixed over the relevant period. Pay rises can increase total labour costs, but they do not automatically indicate financial strength.
- Raw materials
Raw material costs can vary with supply and demand, transport costs, tariffs, weather, exchange rates, and geopolitical conditions. When input prices rise, manufacturers and producers may face higher variable costs unless they can offset them through pricing, efficiency gains or supplier contracts.
- 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
Energy and water costs often include a usage-based component, so they can rise as production or activity increases. Many utility contracts also include fixed standing charges, so they may be partly fixed and partly variable.
Is a marginal cost the same as a variable cost?
Marginal cost is the additional cost of producing one more unit or serving one more customer. It often includes variable costs such as materials, direct labour or transaction costs, but it is not the same as total variable cost. Marginal cost can also change as capacity constraints, overtime, supplier pricing or efficiency levels change.
Understanding total costs
Once you are familiar with fixed and variable costs, you can then take into consideration total costs, which are both the fixed and variable 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 USD 5,000 per month to let its industrial headquarters, as well as USD 2,000 a month to hire its production machinery. It also pays USD 400 a month in insurance. The firm’s total fixed costs would be USD 7,400 a month.
Let’s say Company A also produces 1,000 smartphones a month with variable component costs of USD 20 per unit. It also pays USD 10,000 per month for hourly production labour, linked to output. In this simplified example, total variable costs would be USD 30,000 a month.
Investors may look at total costs to understand how changes in revenue affect margins, profitability and cash generation. Managing costs can support long-term resilience, but profitability also depends on pricing power, demand, debt, investment needs and wider market conditions.
Why it’s important to distinguish between fixed and variable costs
Distinguishing between fixed and variable costs can support two useful analyses: a business’s break-even point and its potential economies of scale.
Once you know a company’s fixed costs, selling price per unit and variable cost per unit, you can estimate the sales volume needed to break even. This is calculated using the break-even analysis formula:
Break-even volume = Fixed costs / (Price per unit – Variable cost per unit)
The formula can provide insight into pricing, cost structure and the number of units a business needs to sell before it becomes profitable. It can also support scenario analysis, such as estimating how higher input costs or lower selling prices could affect margins.
Fixed and variable cost analysis can also help investors assess economies of scale. If fixed costs are spread across a higher number of units, the fixed cost per unit may fall, potentially improving margins if selling prices and variable costs remain favourable.
Ultimately, understanding a company’s fixed and variable costs can help you analyse its cost structure, profitability and resilience, alongside other financial and market factors.