Business Must-Know: What Are Fixed Costs and Variable Costs

Whoever is doing business or planning to start a new venture must understand the types of expenses. The term “cost” is widely used in the business industry, but not all costs are the same. Differentiating between fixed costs and variable costs is essential for financial planning, pricing strategies, and making smart investment decisions.

Why is classifying expenses important?

Before diving into details, consider this scenario: your company’s sales have halved. You want to cut expenses by half as well, but is it possible? Not necessarily.

The company still needs to pay full rent even with lower sales, but can reduce raw material costs when production volume decreases. This difference hinges on understanding the business’s fixed and variable cost structures.

Fixed Costs (Fixed Cost) are you

Fixed costs are expenses that a business must pay regardless of how much it produces or sells. Whether you sell one item or one thousand, the money spent on these costs remains the same.

Key characteristics of fixed costs

Fixed costs have the following features:

• Unrelated to production volume - whether you produce zero or ten thousand units, these costs stay the same
• Predictable and stable - clear data for budgeting
• Impact on per-unit profit - as sales decrease, fixed costs are spread over fewer units, reducing profit per unit

Examples of fixed costs in business

Office and manufacturing space rent
Whether the business is booming or struggling, the rent must be paid monthly to the landlord.

Salaries of permanent staff
Employees managing the company, insurance premiums for contractual employment, fixed monthly payments regardless of sales performance.

Business insurance
Insurance for product quality, building coverage, premiums paid per contract whether accidents occur or not.

Depreciation of assets
When the company purchases machinery or computers, depreciation is calculated monthly according to accounting standards, regardless of whether the equipment is used.

Loan interest
If the company borrows from a bank, interest must be paid as per the agreement, even during periods of loss.

Utilities (Electricity, Internet, Telephone)
Some of these expenses may have basic fixed charges paid monthly, regardless of usage.

Variable Costs (Variable Cost) what are they?

Unlike fixed costs, variable costs change in direct proportion to the quantity produced or sold. The more you produce, the higher the costs; the less you produce, the lower the costs.

Characteristics of variable costs

• Change with production volume - usually directly proportional
• More controllable - reducing production can lower costs
• Affect the break-even point - lower variable cost per unit results in a lower break-even point

Examples of variable costs in business

Raw materials and components
Making ten shirts requires fabric, thread, and buttons proportional to quantity. Producing one hundred shirts requires the same materials multiplied by 10.

Direct labor wages
Workers assembling products are paid based on the number of units produced.

Packaging and wrapping materials
More products to ship mean more boxes, plastics, labels, and logos used.

Transportation costs
More products require more shipping, incurring fuel, labor, and insurance costs.

Sales commissions
Sales staff earning commissions based on sales volume will earn more when sales increase.

Materials, fuel, and production supplies
If the factory uses electricity and gas, costs increase with higher production; part of electricity and gas expenses are variable.

Comparing fixed costs and variable costs

Combining costs and analyzing total cost

In real business management, fixed and variable costs combine into total cost. Understanding and analyzing total cost helps in:

Pricing strategy
Set prices high enough to cover both fixed and variable costs and generate profit.

Production planning
Determine how much to sell to cover all fixed costs (break-even point).

Investment decisions
When considering new machinery, evaluate whether reducing variable costs offsets increased fixed costs.

Cost control
Identify which expenses are excessive and find ways to reduce them.

Understanding figures
As sales change, profits fluctuate more than expected because fixed costs are spread over different units.

Real-world example of cost management

Imagine briefly: ABC Company produces sports shoes.

Normal month

• Produces and sells 1,000 pairs
• Fixed costs: 50,000 THB (rent, salaries, etc.)
• Variable costs: 50,000 THB (fabric, raw materials, wages)
• Total costs: 100,000 THB
• Cost per unit: 100 THB

Good sales month

• Produces and sells 1,500 pairs
• Fixed costs: 50,000 THB (same as before)
• Variable costs: 75,000 THB (proportional to volume)
• Total costs: 125,000 THB
• Cost per unit: 83.33 THB (decreased!)

Poor sales month

• Produces and sells 500 pairs
• Fixed costs: 50,000 THB (still payable)
• Variable costs: 25,000 THB (reduced with volume)
• Total costs: 75,000 THB
• Cost per unit: 150 THB (much higher!)

This example shows that the cost per unit varies with production volume, even with the same capacity.

How to manage costs optimally

For fixed costs

• Negotiate with landlords or service providers to reduce initial expenses
• Consider whether the fixed costs are necessary before signing contracts
• Explore shared workspaces or outsourcing to lower fixed costs

For variable costs

• Find suppliers with competitive prices
• Improve production efficiency to reduce waste
• Optimize packaging to lower shipping costs
• Regularly monitor the ratio of variable costs to revenue

Summary

The difference between fixed and variable costs is not just an accounting statistic but a fundamental business decision-making tool. Understanding their characteristics and behaviors allows you to:

• Set competitive prices - avoid losses but stay affordable
• Plan finances wisely - know how much to sell to stay sustainable
• Reduce costs purposefully - identify where to cut expenses
• Invest prudently - evaluate cost-effectiveness accurately

Every business, big or small, must understand its cost structure. Those who do will build sustainable, profitable enterprises. Those who don’t risk misallocating investments and setting inappropriate prices.