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.