What Are Fixed Costs and Variable Costs?
“What are fixed costs and variable costs?” is a common question and crucial for implementing accurate budgeting, pricing, and long-term planning in your business. Businesses gain clarity on what really makes them money and how to optimize profitability when they fully understand which costs remain steady and which fluctuate.
Classifying costs correctly and applying key financial concepts will help you make smarter, more confident decisions as your business grows. An expert in small business accounting is a key partner in making strategic choices that contribute to business growth.
Variable Expense Definition
Variable expenses are costs that fluctuate in accordance with your business activity. When production increases or sales rise, variable costs increase. They naturally decline when activity slows down. Variable costs have a significant impact on businesses' profit margins and cash flow due to their ever-changing nature.
Common Small Business Variable Expenses
Most small businesses' variable expenses are tied to producing goods, delivering services, or completing customer transactions. Typical examples include:
Raw materials
Cost of goods sold (COGS)
Hourly wages, including overtime tied to production
Shipping costs
Credit card fees
Sales commissions
Per-unit packaging
Fixed Expense Definition
Fixed costs remain the same regardless of sales volume or operational activity. They form the baseline of the cost of running a business as they're predictable and must be covered every month, even during slower periods. Fixed costs provide operational stability but require steady cash flow to cover.
Common Small Business Fixed Expenses
Common fixed costs in small businesses include:
Rent
Insurance
Salaried payroll
Lease payments
Depreciation
Loan interest
Other Accounting Concepts Related to Fixed and Variable Costs
Understanding fixed and variable costs is only part of managing profitability. Several related accounting concepts help business owners price correctly, forecast accurately, and evaluate financial performance. These include:
Contribution Margin
Contribution margin gauges how much each unit sold contributes toward covering fixed costs and generating profit.
A higher contribution margin gives a business more flexibility, while a lower contribution margin requires higher sales volume to stay profitable. Contribution margin is essential for setting prices, analyzing cost changes, and determining the break-even point.
Break-Even Point
The break-even point is the sales volume needed to cover all fixed costs without generating a profit or a loss. It is one of the most important tools in cost-volume-profit analysis.
Once the business passes the break-even point, each additional unit sold contributes directly to profit based on the contribution margin.
Why These Concepts Matter
Together, contribution margin and break-even analysis show:
How much each sale contributes to overhead
How cost changes affect your pricing model
How much volume you need to operate profitably
Understanding these metrics alongside variable and fixed costs helps business owners make smarter decisions about pricing, cost control, and capacity planning.
How Fixed and Variable Costs Impact Small Businesses
Both fixed and variable costs shape a variety of aspects in a business, including pricing, profitability, and cash-flow stability. Covering fixed costs while being prepared for fluctuating variable costs will drive many strategic and financial decisions in your business.
Fixed costs represent a predictable baseline that must be covered every month. This means businesses with high fixed expenses must ensure consistent revenue to stay profitable. Business owners in this situation will prioritize controlling overhead and managing capacity to keep fixed costs under control.
Variable costs impact margins on every unit sold as they rise or fall in line with sales or production volume. This makes them a crucial factor behind pricing decisions, forecasting, and break-even analysis. For example, an increase in variable costs will reduce the contribution margin. This means less money is available to cover fixed costs.
Rising costs signal the need for businesses to analyze how different pricing strategies or more efficient processes to offset extra variable and fixed costs. An expert in small business accounting services can help you restore profitability.
How to Classify Ambiguous or Mixed Costs
Not every business expense fits perfectly into the "fixed" or "variable" cost classification. However, it's important to classify your expenses correctly, as a misclassification will distort your budgeting and profitability analysis.
Many businesses have expenses that change depending on usage, staffing, or production volume. These blended expenses that are made up of fixed and variable components are called semi-variable (or mixed) costs. Correctly classifying mixed costs is a question of separating the fixed and variable portions of each cost.
Most small business owners ask their accountant for help in making these designations accurately. You can then use these insights to plan more accurately for future expenses.
Examples of Mixed Costs
Common examples of mixed costs include:
Labor: Salaried employees are classified as a fixed cost. However, hourly workers, overtime, and project-based contractors are variable costs as they fluctuate in line with workload.
Utilities: Your base service fee is a fixed cost, while usage-based charges vary with activity.
SaaS tools: Your core subscription is fixed, but extras like per-user or usage-based add-ons should be recorded as variable costs.
When to Treat Expenses as COGS or Operating Expenses
Deciding when an expense belongs in COGS or operating expenses is simple when you know how. Follow this rule of thumb to classify your expenses correctly:
If costs are directly linked to producing a product or delivering a service, classify them as COGS. Examples include materials, packaging, and labor during production.
Costs that support the business but don't vary with each unit produced should be classified as operating expenses. This includes rent, software, and admin labor.
Example
Let's imagine a new dental practice in Jacksonville, Florida. During a dental office cost breakdown, they evaluate whether the current price for a routine cleaning is high enough to cover costs and maintain profitability.
The practice has monthly fixed costs of $9,700, including rent, salaries, insurance, and equipment lease.
The variable cost per patient is $17. This includes supplies, sterilization, equipment wear, and payment processing fees.
The dentist charges $120 per cleaning. This leaves a contribution margin of $103 per patient. This means the practice must complete 94 cleanings per month to cover fixed costs ($9,700/ $103 = 94).
The dentist receives between 90 and 95 patients per month. This leaves very little margin for profit. The dentist decides to raise prices by $10 per cleaning, meaning they now only need 86 patients per month to cover fixed costs.
How to Calculate Fixed and Variable Costs
Calculate fixed vs variable costs using the following formulas:
Total Fixed Cost Formula
Add up all your fixed expenses for any given period:
Total Fixed Costs = Rent + Insurance + Salaried Payroll + Lease Payments + Other Fixed Expenses
Example:
$1,000 rent + $500 insurance + $5,000 salaried payroll = $6,500 fixed costs
Variable Cost per Unit Formula
Use this formula to calculate the variable cost per unit:
Variable Cost per Unit = Total Variable Costs/Total Units Produced
Example:
Raw materials, packaging, and fees total $5,000 for 500 units. Variable cost per unit = $5,000/ 500 = $10 per unit
Strategies to Lower Fixed and Variable Costs
Reducing costs will require a balance of quick fixes and long-term changes:
How to Reduce Fixed Costs
Renegotiate rental or lease agreements (e.g., equipment, business premises) to secure more favorable terms.
Identify roles that can be supported by variable contractors to reduce labor costs.
Refinance loans to reduce monthly payments or interest rates.
Evaluate subscriptions and software to reduce unnecessary costs.
How to Reduce Variable Costs
Buy in bulk wherever possible.
Negotiate with suppliers for better pricing or terms.
Streamline internal processes to reduce waste.
Automate repetitive tasks to reduce production-related labor costs.
Optimize shipping methods by switching carriers, changing packaging, or batching shipments.
Improve Efficiency Through a Cost Analysis
Understanding how fixed and variable costs work offers insights into your business’s financial health and long-term profitability. Classifying expenses correctly empowers you to price confidently, plan accurately, and avoid cash-flow surprises.
Your accounting partner will help you apply concepts like contribution margin, mixed-cost analysis, and break-even calculations to make smarter decisions. Your business will then be able to respond effectively to rising costs, improve efficiency, and strengthen your bottom line.
