Lowering your fixed and variable costs increases your profits. But first, you need to know the difference between these two cost categories, and how to tell them apart on your financial statements.
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Here's everything you need to know about fixed vs variable costs, with examples from different industries to help make it stick.
Taken together, fixed and variable costs are the total cost of keeping your business running and making sales. Fixed costs stay the same no matter how many sales you make, while your total variable cost increases with sales volume.
Fixed and variable costs also have a friend in common: Semi-variable costs, which share qualities of each. Here's a brief overview of all three.
Fixed costs stay the same month to month. They aren't affected by your production volume or sales volume.
You can think of them as the price of staying in business: Even if your company isn't making any sale, you have to pay your fixed costs. For instance, no matter how many rubber ducks you sell, your bathtub accessories store still needs to pay rent. And no matter how many clients your home-based acupuncture clinic attracts, you still need to pay property taxes.
Fixed costs appear on your income statement and balance sheet, but they tend to stay the same month to month.
Further reading: Fixed Costs: Everything You Need to Know
Falling under the category of cost of goods sold (COGS), your total variable cost is the amount of money you spend to produce and sell your products or services. That includes labor costs (direct labor) and raw materials (direct materials).
Variable costs increase in tandem with sales volume and production volume. They're also tied to revenue—since the more you sell, the more revenue you have coming in. So, if you sell tote bags, and your sales revenue doubles during the holidays, you'll also see your variable costs—including the cost of wholesale tote bags—increase.
When it's time to cut costs, variable expenses are the first place you turn. The lower your total variable cost, the less it costs you to provide your product or service. So you get to keep more of your revenue as income.
Further reading: Variable Costs: A Simple Guide
Semi-variable costs cost you a minimum amount each month. Above that amount, they cost you more, depending on how much revenue you earn.
One good example: Compensation for employees who earn commission. The sales people at a used car dealership earn a salary—the "fixed" part of the cost. But they also get a commission for every vehicle sold—the "variable" part.
Similarly, many traditional bookkeepers charge a monthly minimum rate, and charge per hour above that; the more business you do, the more transactions your bookkeeper has to categorize, and the more hours they work for you. (Accracy Accounting is a bit different. We charge a flat, predictable monthly rate—making it a fixed cost.)
Light and dark, yin and yang, fixed and variable. Because they're opposites, it may seem like one type of cost is more beneficial than the other. For instance, variable costs eat into your revenue, which is a pain. But fixed costs are harder to reduce"¦ So which is better?
Neither. When you run your own business, you'll have to cover both fixed and variable costs. For some businesses, overhead may make up 90% of monthly expenses, and variable 10%. For others, it may be the other way around. Neither is better or worse.
Bottom line: You should aim to decrease all costs, across the board. When they're lower, the expenses of raw materials and direct labor make you more income. But when your overhead is lower, your income also grows. The most effective approach is to try and reduce both, without obsessing over one or another.
Whether it's the office Christmas party or a week in Acapulco with your top clients, any event you have to plan will come with fixed and variable costs. Variable costs tend to increase with the number of attendees.
In manufacturing, the total cost of direct labor, raw materials, and facility upkeep will take the biggest bite out of your revenue.
Some costs, such as loan payments (most restaurants get initial funding from loans) and equipment depreciation (all restaurants need expensive equipment to operate) are more likely to apply to restaurants than to other types of businesses.
Especially if you run a smaller, home-based ecommerce business, like an Etsy store, you may avoid many of the costs other ecommerce stores deal with.
Now that you understand the differences between fixed and variable costs, it's time to dig in and start reducing your bottom line. Our guide on how to cut costs will get you started.
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