Manage your business costs to the fullest: Understand variable costs and fixed costs to increase profits

In modern business management, categorizing costs into different types is not just a theoretical concept but a key to making smart decisions. From new entrepreneurs to executives of large corporations, everyone needs to understand how to manage these two types of costs to ensure the company’s survival in highly competitive markets and to achieve sustainable profits.

Variable Cost (Variable Cost) and Variable Expenses: The Basics You Need to Know

Variable costs, sometimes called variable expenses, have distinct characteristics that set them apart from fixed costs. These costs directly fluctuate in proportion to the production volume or sales quantity. When your business expands production, variable costs increase accordingly, and conversely, if production decreases, these costs decrease as well.

Key Features of Variable Costs

Variable costs have their own identity, different from fixed costs, whether in accounting or planning. Their main features include:

• Flexibility in Control: Since variable costs are tied to production volume, businesses can adjust them based on market demand, enabling quick responses to demand changes.

• Impact on Cost per Unit: Understanding how much variable cost is incurred per unit helps managers set appropriate selling prices and assess profitability.

• Importance in Estimation: When sales volume is uncertain, knowing how variable costs will change helps in better financial planning.

Examples of Variable Costs: Expenses When Expanding Production

When discussing variable costs, here are common expenses businesses face as production volume changes:

• Raw Materials and Components: Producing more products requires purchasing more raw materials, a clear example of variable costs.

• Direct Labor: Production line workers may need more hours or additional staff as output increases.

• Energy Costs: Electricity and water used in manufacturing will rise with increased production intensity.

• Packaging and Shipping Materials: More products mean more packaging materials and higher shipping costs.

• Sales Commissions: If sales teams earn commissions based on sales volume, this is also a variable cost.

Fixed Cost (Fixed Cost): Expenses That Remain Even Without Production

Unlike variable costs, fixed costs are expenses that a business must pay regardless of whether it produces a lot or a little. Sometimes, these costs are payable even if no production occurs. Fixed costs are stable and predictable, making budgeting easier.

Why Fixed Costs Are Important

Understanding fixed costs is not just for accounting but also for long-term planning:

• Planning Stability: Since these costs do not change, businesses can more accurately estimate revenues and expenses.

• Basis for Pricing: Fixed costs must be considered when calculating the minimum selling price needed to break even.

• Performance Indicator: During high sales periods, fixed cost per unit decreases, leading to higher profits.

Common Fixed Costs

Most businesses encounter these fixed costs whether they are in growth phases or experiencing low sales:

• Rent for Facilities: Whether leasing a factory, office, or showroom, rent remains the same each month.

• Salaries of Permanent Staff: Salaried employees receive fixed wages regardless of company revenue.

• Business and Asset Insurance: Companies need insurance to mitigate risks, and premiums are paid regularly.

• Depreciation of Equipment and Buildings: When a company purchases assets, depreciation is accounted for as a regular cost.

• Long-term Loan Interest: If a company has bank loans, interest payments are due monthly or annually as per the agreement.

Overall Cost Analysis: Gaining a Clearer Picture

The true importance of understanding fixed and variable costs lies in combining these two types to see the total cost burden of the business.

How to Combine Costs and Key Takeaways

Total Cost = Fixed Cost + (Variable Cost per Unit × Number of Units Produced)

This formula appears simple but is crucial for various business decisions:

• Reasonable Pricing: Knowing total costs allows managers to set prices that not only cover expenses but also generate profit.

• Production Planning: Calculating per-unit costs helps determine optimal production levels to keep total costs manageable.

• Financial Risk Assessment: If sales drop by 50%, can the business cover fixed costs? The answer depends on total cost analysis.

Critical Components for Business Decision-Making

• Break-even Point (Break-even Point): Calculated from fixed costs, variable costs, and selling price, this indicates how many units must be sold to avoid losses.

• Investment Decisions: When considering purchasing new equipment (which increases fixed costs), the business must analyze how much this will reduce variable costs to determine if the investment is worthwhile.

• Market Adaptation: As markets change, businesses can adjust strategies by understanding both cost types, enabling effective strategic planning.

Key Differences: A Comparative Table

Conclusion: Cost Management as an Art to Be Learned

Fixed (Fixed Cost) and variable (Variable Cost) are not just accounting concepts but essential tools for managers to lead their businesses to success. Understanding each type, knowing which costs are operational components, and calculating total costs help companies stay competitive in constantly changing environments.

Whether optimizing production efficiency, setting appropriate prices, controlling variable expenses, or planning long-term growth, effective cost management is fundamental. Balancing fixed and variable costs becomes a winning strategy for efficient business management.