Fixed costs and variable costs - Why do businesses need to categorize them?

In modern business management, understanding the cost structure is essential. Specifically, distinguishing between fixed costs and variable costs, which operate differently and significantly impact financial decision-making. Recognizing the differences between these two types of costs not only aids in budgeting but also enables businesses to adapt promptly to market changes.

Fixed Costs (Fixed Cost) - The Ongoing Burden

Fixed costs are like shadows that follow the business regardless of whether products are produced or not. These costs remain constant over time, regardless of increases or decreases in production volume. The business must pay these expenses continuously because they are obligations of operation.

Why Fixed Costs Are Important

Fixed costs determine the (Break-even Point) of a business—that is, the minimum sales volume needed to avoid losses. Knowing fixed costs helps managers set strategic sales targets and pricing strategies. Additionally, it assists in assessing competitiveness and long-term survival prospects.

Characteristics of Fixed Costs

An interesting feature of fixed costs is that as production volume increases, the fixed cost per unit decreases. For example, if a business has rent of 100,000 THB and produces 1,000 units, the fixed cost per unit is 100 THB. If production increases to 2,000 units, the fixed cost per unit drops to 50 THB.

Practical Examples of Fixed Costs

Fixed costs are common in various forms, such as:

• Building and workspace rent - Paid regularly monthly or yearly, regardless of production levels
• Salaries of permanent staff - Full-time employees receive salaries whether or not there is work
• Interest on business loans - Paid periodically as per loan agreements, independent of profits
• Business and asset insurance - Paid annually to mitigate risks
• Depreciation of machinery - Cost decreases over time, regardless of usage
• Interest rates on bonds or long-term debt - Paid to creditors as scheduled

Variable Costs (Variable Cost) - The Fluctuating Element

Variable costs are like waves that rise and fall with production activity. They are high when sales are strong and low when sales decline. This type of cost is more flexible and directly correlates with the level of output.

In-Depth Meaning of Variable Costs

Variable costs reflect operational efficiency. As production increases, variable costs rise proportionally. This characteristic allows businesses to better control these expenses. When sales decrease, businesses can immediately reduce variable costs.

Common Examples of Variable Costs

• Raw materials and components - Purchased according to production volume; more production means more raw material purchase
• Direct labor wages - Hourly or task-based workers; wages depend on workload
• Energy and water costs in manufacturing - Electricity and water usage increase with production volume
• Packaging costs - Buying boxes, envelopes, or wrapping materials based on shipment volume
• Transportation and delivery costs - Shipping expenses increase with the amount of goods transported
• Sales commissions - Sales teams or agents paid based on sales volume

Fundamental Differences: Fixed Costs vs. Variable Costs

Clear differentiation of costs is fundamental to financial analysis. The key differences are:

Why Separate Costs?

Separating these costs helps businesses:

• Set reasonable selling prices - Considering fixed costs spread over sales volume and variable costs per unit
• Assess break-even point - Knowing how much to sell to avoid losses
• Increase profits - Reducing variable or fixed costs to enhance margins
• Make investment decisions - Evaluating whether investing in machinery (increases fixed costs) is worthwhile

Analyzing Mixed Costs - A Managerial Strategy

Mixed cost analysis combines fixed and variable costs to provide an overall picture of total costs the business bears.

How to Calculate Total Costs

The simple formula is: Total Cost = Fixed Cost + (Variable Cost per Unit × Number of Units Produced)

For example, if fixed costs are 500,000 THB and variable cost per unit is 50 THB, and 10,000 units are produced: Total Cost = 500,000 + (50 × 10,000) = 1,000,000 THB

Application in Decision-Making

• Pricing - To achieve a 30% profit margin, the selling price per unit should be 130 THB
• Production Planning - Decide how many units to produce for maximum profit
• Impact Assessment - How a 20% sales decline affects profit
• Cost Reduction - Investing in automation (adding fixed costs 200,000 THB) to reduce variable costs to 30 THB per unit—Is it cost-effective?

Effective Cost Management Strategies

For Fixed Costs

Fixed costs are difficult to reduce but can be managed long-term by:

• Renegotiating rent or reducing workspace
• Cutting down on permanent staff
• Restructuring debt to lower interest payments

For Variable Costs

Variable costs are more flexible and can be improved immediately by:

• Sourcing cheaper raw material suppliers
• Improving manufacturing processes to reduce waste
• Optimizing logistics to save costs
• Increasing workforce training to boost efficiency

Factors Influencing Investment Decisions

Often, businesses must decide whether to choose higher fixed costs (investing in automation) or higher variable costs (more manual labor). When making such decisions, consider:

• Sales level - High and stable sales favor investment in machinery
• Market stability - Uncertain markets favor variable costs
• Payback period - How many years until machinery pays for itself
• Financial capacity - Whether the business has sufficient liquidity for investment

Summary: Why Fixed and Variable Costs Matter

Understanding fixed costs and variable costs, along with their differences, is not just accounting but a fundamental management skill. It forms the basis of budgeting, pricing, cost reduction, and investment decisions.

A business that deeply understands its costs can adapt quickly to market changes, maintain financial stability, and strengthen its competitive position in the long run. Therefore, rational management and comprehension of costs are keys to business success.