Variable vs. Fixed Costs: What Business Leaders Need to Know

Profitability is a guiding star for any business. Reaching — and maintaining — profitability requires business leaders to create financial business plans. This includes spearheading cost management, which can make or break a company’s success. 

For CEOs and CFOs alike, achieving this financial fitness hinges on their capacity to dissect and optimize costs. And while many understand the basics of cost accounting, delving deep into variable and fixed costs can reveal valuable insights that guide strategy.

You can optimize your decision-making and your cost management by better understanding variable vs. fixed costs. Let’s dive in.

Variable Costs vs. Fixed Costs

Variable costs and fixed costs are two fundamental types of business expenses. 

Variable costs fluctuate based on changes in production or sales volume. This means they increase as production or sales rise and decrease when those activities decline. Such costs include expenses such as raw materials, direct labor, and sales commissions. 

Fixed costs, on the other hand, remain constant regardless of production or sales levels. These typically include expenses like rent, salaries of permanent staff, and insurance premiums. 

Now that we’ve discussed how these differ, let’s explore each cost type in more detail.

What Are Fixed Costs?

Fixed costs expenses that remain constant regardless of changes in a company's production or sales volume. These expenditures are essential to maintaining the basic infrastructure and operations of a business, including items like rent or lease payments, salaries of permanent staff, and insurance premiums. 

Since these are less volatile than variable costs, they are typically easier to plan around. They aren’t without challenges, though, since these costs are still necessary during periods of reduced revenue.

By strategically managing fixed costs, businesses can better navigate economic fluctuations and improve their overall financial stability. To adapt or reduce fixed costs, companies can:

• Explore options like renegotiating lease agreements
• Outsourcing non-essential functions
• Embracing flexible work arrangements
• Exploring technology solutions to enhance operational efficiency. 

What Are Variable Costs?

Then there are variable costs. These expenditures fluctuate with changes in production or sales depending on business activity — think raw materials, direct labor, and sales commissions. They don’t typically remain the same from month-to-month or year-to-year. 

Variable costs can vary not between companies and across different industries. For instance, in manufacturing, raw material costs may be a significant variable expense. In the service sector, labor costs might be the dominant expense. To optimize and control variable costs, businesses can employ strategies such as:

• Negotiating favorable supplier agreements
• Implementing lean production techniques
• Closely monitoring production levels for efficiency

Marginal Cost vs. Variable Cost

Variable costs are, at times, confused with marginal costs. While both are used in cost analyses, they each serve a different purpose. 

As established, variable costs change with production or sales, reflecting the costs directly tied to each additional unit produced or sold. Marginal cost, on the other hand, represents the cost of producing one additional unit. Marginal costs are crucial for short-term decision-making, especially in determining whether it's financially viable to increase or decrease production.

For instance, consider a bakery producing bread. The variable cost includes flour, yeast, and labor directly associated with each loaf of bread. The marginal cost, in contrast, signifies the additional cost incurred when making one more loaf of bread. 

Understanding the difference is how business leaders make informed choices about scaling production or setting product prices.

Fixed Costs as Sunk Costs: Truth or Myth?

A sunk cost is money that has already been spent and cannot be recovered. When working on a cost analysis, it’s common to wonder if fixed costs should be treated as sunk costs. 

The short answer is not necessarily. While sunk costs may be considered fixed costs, not all fixed costs are considered sunk costs. 

Consider a manufacturing company with a fixed monthly rent expense for its machine shop. It has already paid this month’s rent, which makes that fixed cost a sunk cost. The rent due for the machine shop next month, however, is not yet a sunk cost because it has not yet been paid. 

Semi-Variable Costs

Semi-variable costs, sometimes known as mixed costs, blur the lines between fixed and variable expenses. This can make them somewhat challenging to categorize. A classic example is employee salary. Whereas a base salary is fixed, overtime pay or bonuses can vary, driving up total compensation. 

For instance, consider a company that employs sales representatives with a fixed base salary but offers performance-based bonuses. In lean months, their fixed component remains stable, but employee incentives fluctuate with sales performance. Recognizing these nuances is crucial for budgeting accurately and incentivizing employees effectively. By acknowledging semi-variable costs and crafting flexible budgeting strategies, businesses can strike a balance between stability and adaptability.

Crafting a Lean Future: Reducing Variable Costs Strategically

Variable costs can be unpredictable and difficult to plan around, so many businesses work to reduce those costs. Doing so not only improves your bottom line, it also positions businesses for sustainable long-term success. 

Following these basic steps can help you execute this variable cost-reduction process.

Step 1: Comprehensive Analysis

Bgin by conducting a thorough analysis of your variable costs. Identify areas where you can make meaningful reductions without compromising quality or efficiency. This involves scrutinizing expenses like raw materials, labor, and distribution costs.

Step 2: Lean Process Implementation

Next, consider implementing lean practices to streamline production and reduce variable costs. This could involve optimizing inventory management, adopting efficient manufacturing techniques, and improving supply chain logistics.

Step 3: Supplier Negotiations

Part of your strategy can be negotiating favorable terms with suppliers to secure cost savings. Consider long-term contracts or bulk purchasing agreements to lower material costs. Collaborative partnerships can lead to discounts or more flexible payment terms, which can ultimately save money and reduce erratic costs.

Step 4: Technology Integration

Many competitive businesses are focused on leveraging technology like AI, automation, and digital transformation to enhance operational efficiency. For example, 44% of businesses have reported cost savings as a benefit of implementing AI, according to The State of Technology in Business World (2023). 

Excitingly, there are a lot of options and technologies that can help businesses become more cost-effective and increase productivity. You can implement data analytics and automation to reduce labor costs and improve decision-making. Using data-driven demand forecasting can also help minimize overproduction and reduce variable expenses.

Step 5: Continuous Monitoring and Adaptation

Once you implement these cost reduction strategies, be sure to regularly monitor and adapt them during changing market conditions. Continuous improvement ensures that your variable costs remain optimized over the long term.

Drive Down a Key Variable Cost: Employee Healthcare 

One of the most vexing variable costs for companies today is employee healthcare. The U.S. already has the highest per-person health spending of any developed country — and those record costs are expected to jump more than 8% in the coming year.

Wellhub, an all-in-one corporate wellness platform, can help cut your healthcare spending. Our clients saw employee healthcare costs reduce by up to 35% in a study of more than 19,000 employees. 

More than 15,000 companies are already saving Wellhub. Talk to a Wellbeing Specialist today!

References

• Yaqub M. (2023, May 16). Technology in Business Statistics 2022: The State of Technology. BusinessDIT. Retrieved November 3, 2023, from  https://www.businessdit.com/technology-in-business-statistics/