What are Fixed and Variable Costs? – Fixed and Variable Costs part 1

This is one way of dividing your costs.

We’ve discussed direct costs and overheads (or indirect costs), which is splitting costs based on their nature.

In this series, we will split costs based on their behaviour: they are either fixed, variable, semi-variable, or stepped fixed.

That is, we’re looking at how the costs behave based on how much you sell.

Let’s say you make toasters.

What are fixed, variable, semi-variable, and stepped fixed costs?

Fixed costs are any which stay the same regardless of your volume of sales.

Rent, insurance, admin, equipment, tools, and executive salaries are all examples of fixed costs.

Variable costs are any which vary based on your volume of sales.

The materials you buy to make your toasters, and the wages of the people who make toasters are variable costs.

There are also semi-variable costs. These are when part of the bill is fixed and part is variable.

Energy bills are semi-variable. Part is fixed: you pay a standing charge every day. Part is variable: you pay more when you use more energy. If this is the energy at your factory, then your energy needs would increase when you’re making more products.

There are also stepped fixed costs. These are when the bill increases in chunks periodically, rather than incrementally for each toaster.

Warehouse space is usually stepped fixed. You need to rent a whole unit at a time, so you might need another warehouse unit for each 10,000 toasters you hold.

What’s the difference between direct and variable costs?

We discussed direct costs earlier, and it’s very easy to confuse the two because there’s a great deal of overlap between them. They are very similar, but not quite identical.

Direct costs are any which are directly attributable to a particular product or project.

Variable costs are any which vary based on your volume of sales.

Here’s a diagram showing how direct costs and variable costs overlap:

You’ll need to look at the individual lines in the direct costs section on your profit & loss report to add up just the direct variable costs, ignoring the direct fixed costs. Anything in red (on the left) on the diagram above should not be considered when calculating your contribution margin.

Then, you’ll need to check your overheads for any variable costs that you should add in.

Energy is often tricky to split between production and offices, so is often coded as an overhead in the accounts. If you can work out a reasonable split to use for your production energy, add that in.

Cloud computing would likely show up as an overhead in your accounts, but it is a variable cost. Cloud computing is a class of software services that allow you to scale up and down with demand. In this example, I’m focusing on the kind of cloud computing you would use for data analysis, where you’re storing more data the more transactions and interactions with customers you have.

Conclusion

So, that’s an overview of what constitutes fixed, variable, semi-variable, and stepped fixed costs, together with some examples.

We looked at how to manipulate your profit & loss report to find your fixed vs variable costs – and we learned that you can ask your finance team to do this for you by preparing a Contribution Income Statement.

Next time, we’ll dive into one way to use this split to manage your small business for more profit.

The Fixed and Variable Costs series

What are Fixed and Variable Costs?

Profitable Price Cuts using your Contribution Margin