In a business, there are two types of costs: fixed and variable. It’s important to understand the difference between these two types of costs, which costs fit into each category, and how to account for them to determine the company’s profitability.
What Is a Fixed Cost?
A fixed cost is one that is not based on how much of a good or service a business produces. It’s sometimes referred to as an indirect cost, or “overhead.”
All businesses have fixed costs, even before they start producing anything.
Fixed Cost Examples
Fixed costs are costs for things that the business needs to operate, whether it is actually producing anything or not. Fixed costs include:
- Rent on the building or premises where the business operates
- Salaries for full- or part-time employees (not hourly paid employees or seasonal workers who are hired based on production needs)
- Interest on loans
- Property taxes
- Utilities, if they are not dependent on production
Some other costs, such as advertising and promotion costs, are fixed costs, but may not be incurred if the company has not yet begun production.
What Are Variable Costs?
Costs that are not fixed are called variable costs. These are the costs that change based on how much of something a company produces.
The cost of materials to produce goods is a variable cost. The more (or fewer) widgets a company produces, the more (or fewer) materials the company will need to purchase in order to be able to make those widgets. Therefore, the total cost of the materials will go up or down depending on how many widgets are produced.
Other examples of variable costs include commissions and wages for seasonal or temporary employees who are hired based on production levels.
Calculating the Break-Even Point
An important financial metric is a company’s break-even point, or the point at which all fixed costs are covered. At breakeven, a company is not making any profit, but it’s not losing money either. Fixed costs must be included in a break-even analysis in order for a company to determine profitability.
Break-Even Point Formula
The formula to determine the break-even point is:
Number of units to break even = fixed costs / (price per unit – variable cost per unit)
Here’s an example. The ABC Company makes widgets. The company has fixed costs of $10,000 per month. Each widget costs the company $3.00 to make, and it sells each widget for $5.00. Using the break-even formula:
X (the number of units needed to break even) = $10,000 (fixed costs) / $5.00 (price per unit) – $3.00 (cost per unit)
X = $10,000 / ($5.00 – $3.00)
X = $10,000 / $2.00
X = 5,000
ABC Company needs to sell 5,000 widgets per month in order to break even. This volume will cover all of the company’s fixed and variable costs. Each widget sold after that will result in $2.00 in profit since the fixed costs will already be covered.
Companies that have high fixed costs have to produce more units in order to break even.
Economies of Scale
When your company produces more units, the fixed costs are spread out over a larger number of units, so the burden on each unit is less. This is referred to as “economies of scale,” and is a powerful way to increase efficiency. The more units you can produce with the same fixed costs, the more profit you can make.
Using the ABC Company example, if the company is paying $3.00 in cost of goods per widget and produces 5,000 widgets in a month, it will break even. If it can get its cost of goods down to $2.50 per widget, it only needs to sell 4,000 widgets per month to break even. After that, each widget will generate $2.50 in profit, not the $2.00 shown in the original example.
Economies of scale can also reduce your variable costs by allowing you to buy materials in bulk or use more efficient production methods.
Can Fixed Costs Vary?
The term “fixed cost” refers to the fact that the cost exists regardless of how many, if any, units are produced. This can be a confusing aspect of fixed costs. They can, in fact, vary from one month or year to another. Salaries are a good example of this — you might hire a new employee or give someone a raise, which would increase your salary expense, yet the cost remains a fixed cost.
How To Reduce Fixed Costs
If a company is trying to cut costs, fixed costs may be a good place to start, but it may mean making significant changes to your business.
Typically, one of the largest fixed costs for a business is salaries. To reduce your salary expense, you could eliminate one or more positions, or institute a pay cut across the board (likely an unpopular decision, especially in the current employment market). You could also change one or more positions from full time to part time.
Another significant fixed cost is rent. To reduce your rent expense, you could renegotiate your lease agreement with your landlord or sublease part of your space. You could also move your business to a less expensive location.
You can look for ways to reduce other fixed costs, like insurance premiums and utilities, by shopping around for less expensive providers.
Understanding the difference between fixed and variable costs, and their impact on your break-even point, will help your business reach and maintain profitability.