The Difference between Variable and Fixed Costs and Why It Matters

1. What Are Variable Costs?

Variable costs fluctuate with production or sales volume. Examples include raw materials, merchant card fees, Pay-Per-Click (PPC) ads, production supplies, or shipping fees.

These costs are directly tied to how much a business produces or sells, making them dynamic and often unpredictable. For instance, a restaurant’s food ingredients are a variable cost; the more meals served, the higher the cost of raw materials like vegetables and meat. Similarly, in manufacturing, labor costs may also fluctuate based on production hours or overtime required to meet higher demand. This variability makes it crucial for businesses to monitor and evaluate these costs regularly to ensure they don’t erode profit margins.

For instance, if you’re an e-commerce retailer, each item sold adds a shipping cost. If sales increase, these costs rise accordingly. Variable costs directly impact your gross margin, making it essential to understand and control them as sales volume grows. For most cases, each additional dollar of revenue will add to the variable cost in some way.

2. What Are Fixed Costs?

Fixed costs, on the other hand, remain the same regardless of sales volume. Think of rent, salaries (for non-commissioned employees), or insurance.

These costs are crucial for calculating your break-even point—the sales volume at which total revenue covers both variable and fixed costs. Even if your sales double, your rent and recurring salaries will remain unchanged in the short term.

Fixed costs provide stability to a business by ensuring certain essential expenses are predictable. They are often associated with the infrastructure and foundational elements needed to operate, such as office space, equipment leases, or long-term software subscriptions. Because these costs don’t fluctuate with sales, they can be a double-edged sword: offering predictability during steady times but posing challenges during downturns. For instance, a retail store’s rent remains constant whether it sells 100 or 1,000 items, making it critical to generate sufficient revenue to cover these fixed expenses consistently. This stability makes fixed costs a key component in long-term financial planning.

3. Why Understanding These Costs Is Vital

Knowing the difference between variable and fixed costs can guide decisions around pricing, budgeting, and profitability.

• If your fixed costs are high, as is often the case with physical storefronts, maximizing sales volume becomes essential to absorb these costs and achieve profitability.
• On the other hand, if your business model leans heavily on variable costs, you may have more flexibility to scale up or down without the pressure of high overhead.

However, be cautious: when sales dip, you need a plan to cover essential fixed costs. Many 7-8 figure businesses encounter this challenge, especially in sectors where demand is seasonal.

That new HR hire might seem like a great investment in the future growth of the company, but when you realize that you need to increase revenue by $75,000 per month to cover that salary, you might want to look into temporary alternatives.

Many business owners think that the bigger your business is, the better and more robust it is. So they go on a hiring spree as soon as they have two months in a row with profit. But what I’ve seen time and again is that the opposite is more true. Stick to a small, close-knit team of troopers that you can depend on. Not only is it easier to manage, but it’s also more profitable.

In order to make effective decisions for hiring, firing, and growing, you need to have a laser-sharp focus on your financials.

How Can You Be Profitable and Not Have Cash?

1- You Need to Buy Inventory

As businesses scale, they often need to invest heavily in inventory to meet growing customer demand. This situation can be misleading when looking at your income statement. Although profits are recorded from sales, these gains might be tied up in inventory purchases.

As a result, your cash reserves might appear low, or even negative, as capital is tied up in assets that are not yet liquid. This often leads to the need for additional borrowing to support operations, creating a potential cash flow strain.

To manage this effectively, businesses should forecast inventory needs carefully, aligning purchases with expected sales trends. Additionally, negotiating payment terms with suppliers can provide some breathing room and reduce the strain on cash reserves.

The Different Types of Revenue and Why They Matter

At its core, revenue may look like a single figure on your income statement, but breaking it down reveals various types, each with unique implications.

Recurring Revenue

Let’s first examine recurring revenue, which includes subscriptions, retainers, or maintenance contracts that bring a steady income. For instance, SaaS companies or service-based businesses often rely on recurring revenue to maintain stable cash flow, making planning much easier.
Recurring revenue provides a sense of security. It’s predictable, reliable, and often grows over time as customers stay loyal. Businesses like gyms, software subscriptions, and consulting firms benefit greatly from this revenue type. The best part? With a solid recurring revenue model, you can focus less on constant customer acquisition and more on delivering excellent service, which leads to even higher customer retention rates.

Project Based Revenue:

Project-based revenue or one-off sales, on the other hand, can lead to higher profits but come with unpredictability. Think about a marketing agency that secures a large campaign contract for three months; it’s a big boost, but once it ends, cash flow could take a hit if there isn’t another contract lined up. And sometimes the cash flow can be difficult to predict, because a project might have some milestones along the way. You don’t get paid until you hit the milestone. But you still have to pay your time.

To handle the unpredictability of project-based revenue, businesses should prioritize building a steady flow of projects and nurturing strong relationships with clients. Keeping multiple projects in different stages of development can act as a safety net, reducing the risk of sudden revenue shortages. Another effective strategy is to set up clear payment plans, like phased payments linked to project milestones. This approach not only helps maintain consistent cash flow but also ensures smoother operations without financial hiccups.

One-off sales are what most e-commerce business owners live off of. This is basically just people coming in the door to your store (virtually). But here’s the key: in order to get profitable, you need to understand how you can maximize those sales. There are a couple of important ways to maximize them. One is to get more people to come in to the store, another is the upsell (getting them to by more), and finally, if you can make them come back, you might something really special. The more you can make them come back, the more profit you can make.