The difference between fixed and variable costs

Financial Events
Saxo Be Invested

Saxo Group

When you are looking at the balance sheet of a potential equity to invest in, it’s important to be clear on the difference between a company’s fixed and variable costs. Businesses of all shapes and sizes have two kinds of cost when they deliver their goods or services – fixed costs and variable costs.

Let's explore the nuances between fixed and variable operating costs for business, along with real-world examples. We’ll also explain the value of distinguishing between fixed costs and variable costs from an investment perspective. 

What are fixed costs?

Fixed costs are a type of business expense that a company is contractually obliged to pay. They are usually time-linked, too. A fixed cost is something that does not evolve over time. As they are largely set in stone, fixed costs typically form the ‘base costs’ of a company’s day-to-day operations. 

Generally, fixed costs will significantly influence an equity’s overall profitability. That’s because these charges are due irrespective of the company’s business activities, i.e. how many goods or services it sells.

Fixed costs for a business can be considered direct or indirect costs. A direct cost is intrinsically linked to the design, manufacture, or sale of goods or services. This could be a commercial lease on-premises over a fixed term. An indirect cost fluctuates more readily. Using the same commercial lease example, the energy bills to power the company’s premises would be an indirect cost as, although it is used within the premises, it can’t be influenced by the unit. 

Examples of fixed costs 

A fixed cost stays the same, regardless of whether production output rises or falls. Common examples of a fixed cost within a business’ balance sheet include: 

  • Commercial rent
    Most commercial rents will have a fixed monthly or annual cost for a business, at least during the initial term of the rent agreement. Even when the rent of a lease changes at the end of an initial term, this usually becomes a new fixed cost if the new term is more or less expensive.
  • Online advertising
    If a company has an online advertising budget of $10,000, this is a fixed cost as the top line figure does not change. The company has ring-fenced $10,000 as a fixed cost to cover its online advertising and will not pay a penny more or less.
  • Insurances
    The cost of insurance premiums to cover a company’s property or assets is typically a fixed cost. Although sometimes insurances can be variable, such as the cost of worker compensation insurance, which may or may not be needed.
  • Depreciation
    The depreciation of assets is also a fixed cost. Companies will typically devise a depreciation expense schedule for all their assets, with their values declining over time. Depreciation isn’t a variable cost because the decline in assets isn’t determined by its activity volume. 

Are fixed costs considered sunk costs? 

In financial accounting terms, sunk costs are all fixed costs – but that doesn’t mean all fixed costs are sunk. Sometimes in the lifespan of a business where a fixed cost isn’t irretrievable. For instance, when a company purchases production machinery for its warehouse, although it is a fixed cost, it is not a sunk cost. That’s because the business can sell on its used machinery to recoup some or all of the initial purchase cost.

A company’s monthly fuel costs – which cover its vehicle fleet – is the prime example of a sunk cost. It’s not possible to reclaim the petrol or diesel used to drive from A to B. 

What are variable costs? 

The difference between variable costs and fixed costs is that the former is intrinsically linked to the output of the company. Variable costs rise and fall as production increases or decreases. The easiest way for an investor to calculate the variable costs of a business is to multiply the output of a company by the variable cost per unit of its output. 

Let’s say Company A manufactures 1,000 vehicles at a cost per unit of $5,000. Its variable cost for total production would be $5m. However, if Company A struggled to source materials or electrical components for new vehicles the following year and only built 400 new vehicles – at a higher cost per unit of $8,000 because of material shortages – its variable cost for total production would be $3.2m. 

As you can see, the total variable cost to produce a company’s goods or services will directly influence the bottom line of a business. In fact, the fluctuation of variable costs for a business is one of the main drivers of the rise or fall of its share price. When costs rise – eating into profits – the share price is more likely to fall. 

Examples of variable costs 

A variable cost is exactly that – variable. It can rise and fall based on a company’s productivity. Common examples include: 

  • Labour
    Employment costs vary from year to year. If a company takes on more employees, its labour costs will rise. Similarly, if a company is forced to grant a pay rise to its staff, its labour costs will also rise. Sometimes an above-inflation pay rise to staff can be a show of fiscal strength from a company.
  • Raw materials
    The cost-of-living crisis experienced across the UK and beyond right now relates to many raw materials. With trade barriers and supply chain issues increased because of the ongoing crisis in Ukraine and the Covid-19 pandemic, the price of raw materials has risen significantly. This has seen variable costs rise for many manufacturers and producers.
  • Commissions
    If a company pays a commission on every sale, this will be a variable cost. That’s because the amount a business pays in commission will be linked to the number of sales it makes.
  • Utility costs
    The fluctuation of gas, electricity and oil has influenced utility charges for businesses. The more energy a business uses, the more it has to pay, hence why it’s a variable cost on the balance sheet.

Is a marginal cost the same as a variable cost? 

Variable costs can fall under the umbrella of a marginal cost. Marginal costs relate to business expenses linked to the production of new units of output or the serving of an additional customer. They are incremental costs that increase over time to help produce additional units of output. As part of the outlay for production, variable costs are included as a marginal cost most times. 

Understanding total costs

Once you are familiar with fixed and variable costs, you can then take into consideration total costs, which are both of the above costs combined. Total fixed costs will cover all expenses a company is contractually obliged to pay. For argument’s sake, let’s say Company A pays $5,000 per month to let its industrial headquarters, as well as $2,000 a month to hire its production machinery. It also pays $400 a month in insurance. The firm’s total fixed costs would be $7,400 a month.

Let’s say Company A also produces 1,000 smartphones a month for $20 per unit, inclusive of all electrical components that need importing from Asia. It has a staff wage bill of $10,000 per month, too. Its total variable costs would be $30,000 a month.

Ultimately, potential investors need to keep a keen eye on a company’s total costs. Keeping a lid on total overheads is vital to ensure the long-term sustainability and solvency of a business – and publicly listed corporations are no different. 

Why it’s important to distinguish between fixed and variable costs 

As a prospective investor, being able to establish the difference between a company’s fixed and variable costs can help you make two further key calculations – a business’ break-even point and the identity of economies of scale.

Once you are aware of a company’s fixed and variable costs, it’s possible to determine the price point that a business must hit to maintain profitability. This is achieved by undertaking the break-even analysis formula: 

Fixed costs / price – variable costs = volume needed to break even 

The formula provides insight into a company’s pricing structure, and it can also provide a picture of how many more units a business would need to sell if its variable costs increased due to ambitious expansion. There’s also an opportunity for prospective investors to make basic forecasts for a company’s projected profits during the current trading year. This is beneficial if it’s a company that regularly pays dividends to shareholders. 

Once you have a firm grasp of a company’s fixed and variable outgoings, these figures can also be manipulated to find out their economies of scale. It’s possible to determine the sweet spot of a company’s finances, where increased output meets fixed costs spread across a greater number of items. 

Ultimately, by mastering a company’s fixed and variable costs, you can get immediate insight into a firm’s cost structure and make clear, rational decisions based on the likely short and long-term profitability of a business. 

Quarterly Outlook

01 /

  • Macro Outlook: The US rate cut cycle has begun

    Quarterly Outlook

    Macro Outlook: The US rate cut cycle has begun

    Peter Garnry

    Chief Investment Strategist

    The Fed started the US rate cut cycle in Q3 and in this macro outlook we will explore how the rate c...
  • Fixed Income Outlook: Bonds Hit Reset. A New Equilibrium Emerges

    Quarterly Outlook

    Fixed Income Outlook: Bonds Hit Reset. A New Equilibrium Emerges

    Althea Spinozzi

    Head of Fixed Income Strategy

  • Equity Outlook: Will lower rates lift all boats in equities?

    Quarterly Outlook

    Equity Outlook: Will lower rates lift all boats in equities?

    Peter Garnry

    Chief Investment Strategist

    After a period of historically high equity index concentration driven by the 'Magnificent Seven' sto...
  • FX Outlook: USD in limbo amid political and policy jitters

    Quarterly Outlook

    FX Outlook: USD in limbo amid political and policy jitters

    Charu Chanana

    Head of FX Strategy

    As we enter the final quarter of 2024, currency markets are set for heightened turbulence due to US ...
  • Commodity Outlook: Gold and silver continue to shine bright

    Quarterly Outlook

    Commodity Outlook: Gold and silver continue to shine bright

    Ole Hansen

    Head of Commodity Strategy

  • FX: Risk-on currencies to surge against havens

    Quarterly Outlook

    FX: Risk-on currencies to surge against havens

    Charu Chanana

    Head of FX Strategy

    Explore the outlook for USD, AUD, NZD, and EM carry trades as risk-on currencies are set to outperfo...
  • Equities: Are we blowing bubbles again

    Quarterly Outlook

    Equities: Are we blowing bubbles again

    Peter Garnry

    Chief Investment Strategist

    Explore key trends and opportunities in European equities and electrification theme as market dynami...
  • Macro: Sandcastle economics

    Quarterly Outlook

    Macro: Sandcastle economics

    Peter Garnry

    Chief Investment Strategist

    Explore the "two-lane economy," European equities, energy commodities, and the impact of US fiscal p...
  • Bonds: What to do until inflation stabilises

    Quarterly Outlook

    Bonds: What to do until inflation stabilises

    Althea Spinozzi

    Head of Fixed Income Strategy

    Discover strategies for managing bonds as US and European yields remain rangebound due to uncertain ...
  • Commodities: Energy and grains in focus as metals pause

    Quarterly Outlook

    Commodities: Energy and grains in focus as metals pause

    Ole Hansen

    Head of Commodity Strategy

    Energy and grains to shine as metals pause. Discover key trends and market drivers for commodities i...

Disclaimer

The Saxo Bank Group entities each provide execution-only service and access to Analysis permitting a person to view and/or use content available on or via the website. This content is not intended to and does not change or expand on the execution-only service. Such access and use are at all times subject to (i) The Terms of Use; (ii) Full Disclaimer; (iii) The Risk Warning; (iv) the Rules of Engagement and (v) Notices applying to Saxo News & Research and/or its content in addition (where relevant) to the terms governing the use of hyperlinks on the website of a member of the Saxo Bank Group by which access to Saxo News & Research is gained. Such content is therefore provided as no more than information. In particular no advice is intended to be provided or to be relied on as provided nor endorsed by any Saxo Bank Group entity; nor is it to be construed as solicitation or an incentive provided to subscribe for or sell or purchase any financial instrument. All trading or investments you make must be pursuant to your own unprompted and informed self-directed decision. As such no Saxo Bank Group entity will have or be liable for any losses that you may sustain as a result of any investment decision made in reliance on information which is available on Saxo News & Research or as a result of the use of the Saxo News & Research. Orders given and trades effected are deemed intended to be given or effected for the account of the customer with the Saxo Bank Group entity operating in the jurisdiction in which the customer resides and/or with whom the customer opened and maintains his/her trading account. Saxo News & Research does not contain (and should not be construed as containing) financial, investment, tax or trading advice or advice of any sort offered, recommended or endorsed by Saxo Bank Group and should not be construed as a record of our trading prices, or as an offer, incentive or solicitation for the subscription, sale or purchase in any financial instrument. To the extent that any content is construed as investment research, you must note and accept that the content was not intended to and has not been prepared in accordance with legal requirements designed to promote the independence of investment research and as such, would be considered as a marketing communication under relevant laws.

Please read our disclaimers:
- Notification on Non-Independent Investment Research (https://www.home.saxo/legal/niird/notification)
- Full disclaimer (https://www.home.saxo/en-gb/legal/disclaimer/saxo-disclaimer)

Saxo
40 Bank Street, 26th floor
E14 5DA
London
United Kingdom

Contact Saxo

Select region

United Kingdom
United Kingdom

Trade Responsibly
All trading carries risk. To help you understand the risks involved we have put together a series of Key Information Documents (KIDs) highlighting the risks and rewards related to each product. Read more
Additional Key Information Documents are available in our trading platform.

Saxo is a registered Trading Name of Saxo Capital Markets UK Ltd (‘Saxo’). Saxo is authorised and regulated by the Financial Conduct Authority, Firm Reference Number 551422. Registered address: 26th Floor, 40 Bank Street, Canary Wharf, London E14 5DA. Company number 7413871. Registered in England & Wales.

This website, including the information and materials contained in it, are not directed at, or intended for distribution to or use by, any person or entity who is a citizen or resident of or located in the United States, Belgium or any other jurisdiction where such distribution, publication, availability or use would be contrary to applicable law or regulation.

It is important that you understand that with investments, your capital is at risk. Past performance is not a guide to future performance. It is your responsibility to ensure that you make an informed decision about whether or not to invest with us. If you are still unsure if investing is right for you, please seek independent advice. Saxo assumes no liability for any loss sustained from trading in accordance with a recommendation.

Apple, iPad and iPhone are trademarks of Apple Inc., registered in the U.S. and other countries. App Store is a service mark of Apple Inc. Android is a trademark of Google Inc.

©   since 1992