Variable and Fixed Costs

Variable costs are expenses that change in proportion to production or sales volume, such as raw materials or labor costs. Fixed costs, on the other hand, do not change with the level of production or sales and include expenses such as rent, insurance, and salaries.

Key takeaways

• Variable costs are expenses that fluctuate with the level of production or sales, such as raw materials and direct labor costs.
• Fixed costs are expenses that do not fluctuate with the level of production or sales, such as rent and salaries.
• Variable costs can be semi-variable or mixed costs, which have both a fixed and a variable component.
• Fixed costs can become variable costs under certain circumstances, for example when a company has excess capacity or is downsizing.
• Fixed costs can be divided into discretionary and committed fixed costs.

Why Are Both Important for Liquidity Planning?

Both variable and fixed costs are important for liquidity planning because they both affect a company's cash flow.

Variable costs directly impact the amount of cash a company needs to pay out in the short term, as they increase or decrease with changes in production or sales. While fixed costs are not directly tied to production or sales, they represent ongoing expenses that a company must pay regardless of its activity level. A thorough understanding of both cost types can help a company plan its short- and long-term cash needs and make more informed decisions about its operations and finances.

Variable Costs

Variable costs are expenses that fluctuate with the level of production or sales.

👉🏻 Examples include costs for raw materials, commission payments, and direct labor costs.

These costs can be calculated by determining the cost per unit of production or sale and multiplying this amount by the number of units produced or sold. For example, if the raw material cost to manufacture one unit of a product is $10 and 1,000 units are produced, the variable costs for raw materials amount to $10,000. To determine variable costs, you need to research and identify the material and labor costs as well as other factors that change with the level of production or sales.

Fixed Costs

Fixed costs are expenses that do not vary with the level of production or sales.

These costs are incurred regardless of whether the company produces or sells products.

👉🏻 Examples include rent, salaries, and insurance. Fixed costs are often referred to as overhead costs.

Unlike variable costs, fixed costs do not change with the number of units produced or sold. For example, if a company rents a factory for $10,000 per month, this cost remains the same regardless of whether the company produces 10 or 10,000 units. To determine fixed costs, you need to research and identify the costs that do not change with the level of production or sales. These are costs incurred to keep the business running, regardless of production or sales volume.

What About Semi-Variable Costs or Committed Fixed Costs?

🤓 What not everyone may know about variable costs is that they can also be semi-variable or mixed costs. These costs have both a fixed and a variable component. For example, a company may have a fixed monthly phone bill but also pay a variable amount per call made. To accurately calculate total costs, the fixed and variable cost components must be identified and separated.

🙃 What not everyone may know is that fixed costs can become variable costs under certain circumstances. For example, if a company has significant excess capacity, it may negotiate lower rents or other fixed costs with its landlords or suppliers. If the company decides to downsize or close a facility, fixed costs can become variable costs since the company no longer needs to incur these expenses.

👉🏻 Finally, not everyone may know that fixed costs can be divided into discretionary and committed fixed costs. Discretionary fixed costs are expenses that management can easily adjust and that are not absolutely necessary for normal business operations. Committed fixed costs are expenses required for the normal operation of the business and cannot be easily adjusted. An example of this would be factory rent, which belongs to committed fixed costs, versus hiring a celebrity for a commercial, which belongs to discretionary fixed costs.

👍🏼 Tip: You can use variable and fixed costs relatively easily in a liquidity planning software