066: Understanding Fixed and Variable Costs

Everyone in your management chain – and everyone in a leadership position at your company is making decisions based on your company’s financial position every day. So, it is important for you to have some basic understanding about some of the core building blocks of financials. If you understand these, you are better able to understand why your leadership team makes some of the decisions they do. It helps to give you better insight. It helps you better understand the strategy decisions they are making. And, it helps you better anticipate what decisions they might make in the future.

Today we are going to talk about the difference between fixed and variable cost. If you can really understand this concept, you’ll have a better ability to analyze business strategy. So, this is fixed and variable cost 101.

Fixed Cost
Fixed cost is any cost incurred by your company that doesn’t change based on the business. So, for example, the rent paid for your office is fixed. Whether you make $100 in sales this month, or $1,000000, the rent is the same.

If you are in a manufacturing business that has large equipment – that equipment is a fixed cost. It is likely that there is some sort of monthly payment on the equipment that has to be made regardless of sales.

If you are in the transportation business, you likely have a fleet of trucks that are being paid for each month.

If you are working for a start up, maybe your company has taken out a loan. That loan payment is a fixed expense.

Chances are good that your company has some sort of insurance – whether it is liability insurance, key man insurance, or something specific to your industry. The insurance payment is fixed. It doesn’t change based on the volume of your sales.

Variable Cost
The other type of cost is variable. Variable costs fluctuate based on volume. Inventory is a classic variable cost. Whatever business you are in, if it involves inventory, then your company can control costs by controlling inventory. You pay based on the volume you buy. So, if you are in a seasonal business, you would minimize the cost of inventory during the months that are not part of your season and your costs would go way up in the months that were your season.

What if you are in an industry that doesn’t involve inventory? Maybe you work for a software company or an accounting firm. In that case, the largest variable cost is salary expense. The amount of expense is going to increase or decrease based on the number of employees.

Services businesses like software, accounting, real estate, consulting – the largest expense they have is the cost of employees. So, the best way to control costs is to control headcount. In an accounting or consulting business where revenue is linked directly to headcount because you are literally charging by the hour – then the costs that the business incurs automatically goes up or down with the revenue.

For a software business – there isn’t as much of a direct link. You can sell a lot more software licenses without having to add more developers.

But, the fact still remains that salary expense is a variable cost because it increases or decreases based on the number of employees. So, your salary, regardless of what industry you work in, is a variable expense for your company.

Benefits are also variable expenses. Each time they add headcount, they also add expenses related to whatever benefits are offered.

Financial Decisions
So, you can start to see how understanding fixed versus variable costs is important. The leaders of your company have to make decisions based on the specific situation they are in. As they are making decisions, they have to look at the options based on what is variable and what is fixed. And, these aren’t always easy decisions. If you see your company making some belt tightening decisions, it could be an indicator that cash is tight and they are looking for ways to decrease variable costs in order to be able to ensure they can cover their fixed costs during a lean time.

And, on a side note – all of this applies at home as well. What are your fixed and variable costs at home? You are constantly making decisions based on this and may not even realize you are doing it.
 
You can learn more about financial acumen with our Financial Acumen Curriculum.