How to manage business costs: The difference between fixed costs and variable costs

When it comes to business management, distinguishing between different types of costs is an essential fundamental that cannot be overlooked. This is because every business faces two types of expenses: Fixed Costs and Variable Costs.

Smart management of both types will help your company set appropriate prices, plan production efficiently, and most importantly, accurately forecast profits and plan for long-term growth.

Fixed Costs: Expenses That Do Not Change

(Fixed Cost) refers to the business expenses that remain the same regardless of whether the company produces more or fewer goods. The term “fixed” indicates that these costs will stay and must be paid regularly, even during periods when the business is not operating.

Fixed costs arise from long-term commitments of the company, such as property lease agreements, agreed-upon salaries, or interest on loans. Because these costs are stable, they allow the company to confidently use these figures for financial planning and annual budgeting.

Examples of fixed costs that companies incur monthly

Rent and utilities - Office or factory rent paid monthly, regardless of sales volume, including building cleaning, maintenance, and public utilities.

Salaries and employee benefits - Regular wages paid to staff according to contracts, including basic benefits, social security, and minimum life insurance premiums.

Business insurance - Insurance premiums for equipment, goods, and various liability insurances that must be paid annually.

Depreciation of fixed assets - Calculating depreciation for machinery, office buildings, company vehicles, and other equipment invested in initially.

Loan interest - Monthly or annual interest payments on loans borrowed from banks or other creditors, payable as scheduled.

Key characteristics of fixed costs

Fixed costs do not increase or decrease with fluctuations in production volume. Whether a company produces 100 units or 1,000 units, rent remains the same. This makes fixed costs a stable component in budgeting.

However, this characteristic can be a double-edged sword: if sales decline, fixed costs become a heavier burden, significantly increasing the cost-to-revenue ratio and reducing profits.

Variable Costs: Expenses That Change with Production

In contrast to fixed costs, (Variable Cost) refers to business expenses that directly fluctuate with the level of production or sales. When a company increases production, variable costs increase proportionally; when production or sales decrease, variable costs decrease accordingly.

The hallmark of variable costs is their direct correlation with actual operations. When a company needs to produce more to meet market demand, variable costs will follow suit. Conversely, if the market is less favorable, the company can reduce production and variable costs will decrease.

What do variable costs include?

Raw materials and production components - Costs of fabrics, metals, or other materials used in manufacturing. The more you produce, the more raw materials you need to purchase.

Direct labor costs - Wages for workers directly involved in production. If paid per piece or per hour, these costs will fluctuate with production volume.

Energy and water costs in manufacturing - Electricity and water used in production lines. More machinery running means higher energy consumption.

Packaging materials and boxes - Cardboard boxes, plastic bags, cushioning materials, or other packing supplies used for wrapping and storing products.

Transportation and logistics - Expenses for delivering goods from factories to distribution centers or customers. Higher sales volume results in higher transportation costs.

Sales commissions and incentives - Compensation for sales teams based on performance or special incentives upon reaching targets.

Importance of understanding variable costs

For decisions related to production volume, pricing, and short-term planning, understanding variable costs is essential. Companies that can control variable costs effectively will be able to adapt their production strategies quickly and efficiently according to market conditions.

Additionally, tracking variable costs helps companies monitor process efficiency, detect damages or waste, and continuously improve operations.

Comparing Fixed and Variable Costs: What Are the Differences?

To help you clearly understand the differences, consider a business perspective. Suppose you own a clothing manufacturing factory:

Factory rent (Fixed Cost): Whether you produce 1,000 shirts or 100,000 shirts this month, the rent remains at 100,000 THB/month.

Fabric and thread used (Variable Cost): If you produce 1,000 shirts, you need 5,000 meters of fabric; if you produce 10,000 shirts, you need 50,000 meters. Costs increase proportionally.

Key figures to remember:

• Fixed costs: Do not change, stable, paid every month.
• Variable costs: Change with volume, flexible, increase or decrease with production.

This distinction plays a crucial role in decisions about new investments, increasing production capacity, or entering new markets. Companies with high fixed costs (such as consulting firms or other small businesses) may need to produce larger quantities to cover those expenses. Meanwhile, companies with high variable costs (such as research firms or small-scale businesses) can scale operations up or down quickly according to demand.

Analyzing Total Costs for Better Business Decisions

When a company wants to evaluate its financial potential, the best approach is to combine fixed and variable costs. This is called Total Cost, and it is a powerful decision-making tool.

Total Cost = Fixed Costs + (Variable Cost per Unit × Production Volume)

This calculation helps answer key questions such as:

• What should be the selling price per unit to cover costs and generate profit?
• How many units need to be produced to reach the break-even point (Break-even point)?
• If prices are lowered, how much additional production is needed to remain profitable?
• How will the cost per unit change if production volume increases?

Practical Applications

Companies that know how to manage both types of costs often have a competitive advantage. For example:

• They might decide to invest in automation machinery (increase fixed costs) to reduce labor costs (decrease variable costs) over the long term.
• They can make smart pricing adjustments that not only keep them competitive but also maintain healthy profits.
• They can plan for hiring new staff or downsizing operations with minimal risk.

Summary of Fixed and Variable Costs

Understanding the difference between Fixed Costs and Variable Costs is the foundation of good financial management. Fixed costs are expenses that must be paid under all circumstances, such as rent and salaries, while variable costs change with the level of activity, such as raw materials and wages. Both types of costs enable businesses to:

• Set appropriate and fair selling prices
• Plan production to meet demand
• Identify break-even points and sales targets
• Assess competitiveness
• Develop sustainable growth strategies

Businesses with deep knowledge of their cost structures will be better positioned to lead their enterprise toward long-term success and sustainability.