How to classify costs in a business: fixed costs and variable costs

Every business faces cost management challenges daily, whether it’s a small grocery store, a manufacturing plant, or a service company. Understanding the different types of costs is essential for managers to make smart decisions—setting prices, planning production, or assessing competitiveness.

Distinguishing between fixed and variable costs isn’t as difficult as it seems. This article explores both types of costs practically, helping you see how they influence daily business operations.

Fixed Costs: The Heart of Long-Term Planning

Fixed Cost refers to expenses that do not change with production or sales volume. For example, a coffee shop with 100 cups sold still incurs the same fixed costs as when selling only 10 cups. This is a key characteristic of this cost category.

Features of Fixed Costs

Fixed costs are highly stable. Whether the business is doing well or poorly, these costs must be paid regardless of revenue. This presents both challenges and planning advantages:

• Consistency: Knowing your monthly expenses makes financial planning easier.
• Necessity: These costs relate to essential operations and cannot be easily deferred or avoided.

Common Fixed Cost Examples

Understanding fixed costs helps you identify expenses to manage:

• Rent: Store, office, or factory rent remains constant monthly or yearly.
• Salaries: Regular employees with fixed monthly wages.
• Insurance: Business insurance premiums paid regularly.
• Depreciation: Accounting for wear and tear of machinery, equipment, or buildings.
• Loan interest: If the business has borrowed funds, interest payments are fixed based on the loan amount.

This category is important because it indicates the “minimum cost” the business must cover to operate.

Variable Costs: The Sales Partner

Variable Cost refers to expenses that fluctuate with production or sales volume. The more you sell, the higher the variable costs; the less you sell, the lower they are. This flexibility is a defining feature of this cost type.

Features of Variable Costs

Variable costs are directly proportional to sales:

• Flexibility: You can control these costs by adjusting production levels—selling less reduces costs.
• Relationship: They increase with sales volume and decrease when sales decline, reflecting market-driven management.

Examples of Variable Costs

Knowing which costs are variable helps you understand how expenses change with sales:

• Raw materials and components: More production requires more materials.
• Direct labor: Piece-rate workers or hours worked based on output.
• Energy and water: Increased machine operation raises utility costs.
• Packaging and shipping: More products require more packaging and transportation.
• Sales commissions: Commissions based on sales volume increase as sales grow.

Variable costs are more controllable since they can be adjusted through production and sales strategies.

Comparing Fixed and Variable Costs: The Manager’s Lifecycle

Distinguishing between fixed and variable costs is like asking yourself: “Does this expense change with sales volume?” Once you can answer that, you can categorize costs effectively.

Key Differences

Why Understanding Both Matters

Managers with a clear grasp of cost types can make smarter decisions:

• During downturns: Fixed costs remain burdensome; focus on increasing sales or reducing variable costs.
• When expanding: Increasing production raises variable costs but fixed costs may stay stable, offering economies of scale.
• Pricing decisions: Knowing your cost structure helps set prices that cover both fixed and variable costs.

Total Cost Analysis: Making Business Decisions

Total cost combines fixed and variable costs, giving a complete picture of resources needed:

Calculation and Practical Use

Understanding cost types allows you to:

• Analyze breakeven point: The sales volume where revenue equals total costs.
• Set appropriate prices: Knowing total cost per unit helps determine profitable prices.
• Plan growth: Increasing production raises variable costs but can lower fixed costs per unit (economies of scale).
• Invest wisely: Capital investments (increasing fixed costs) can reduce variable costs long-term.

Practical Example

A coffee shop owner knows fixed costs are 50,000 THB/month, and variable cost per cup is 30 THB, with a selling price of 80 THB. To break even:

• Minimum sales needed = 50,000 ÷ (80 - 30) = 1,000 cups/month.

Beyond that, each additional cup sold contributes to profit.

Learning from Cost Management

Different industries balance fixed and variable costs uniquely:

• Service businesses: Often have high fixed costs (rent, salaries) but low variable costs.
• Retail: High variable costs (inventory purchase) with flexible fixed costs.
• Manufacturing: Both fixed and variable costs are significant.

Effective management of both cost types is key to long-term success.

Summary: Costs as Tools, Not Just Numbers

This article shows that cost types are more than academic concepts—they are practical tools for daily decision-making:

• Informed planning: Understand your minimum expenses and variable components.
• Cost control: Identify controllable costs and unavoidable expenses.
• Investment decisions: Recognize how investments shift cost structures.
• Competitive pricing: Use cost insights to set strategic prices.

Simplifying cost management by categorizing costs enhances decision clarity, reduces operational complexity, and is fundamental to effective, long-term business success.