Fixed costs and variable costs: Essential understanding for entrepreneurs

When managing a business, understanding the cost structure is the most critical factor. The costs incurred in operations are divided into two main categories: (Fixed Cost) and (Variable Cost). The ability to distinguish and manage these two types of costs will help managers make effective decisions on pricing, product strategy design, and growth planning.

Understanding the Basic Differences

In modern business operations, all cost components consist of two clearly distinct parts. Fixed costs are expenses that do not change regardless of how much the business produces or sells. In contrast, variable costs increase or decrease proportionally with production and sales levels.

Understanding this difference is not just theoretical; it is a practical tool that helps businesses calculate the break-even point, set appropriate selling prices, and manage cash flow accurately.

Fixed Cost (Fixed Cost): Unavoidable Expenses

Fixed costs refer to expenses that a business must pay monthly or annually regardless of the production level. Whether you produce 100 units or 1,000 units, these costs remain the same and must be paid.

Characteristics of Fixed Costs

Fixed costs are characterized by stability. These expenses do not fluctuate with customer orders or market demand. The importance of fixed costs lies in their role as the initial step in calculating net profit because, regardless of sales volume, fixed costs are liabilities that need to be covered.

Calculating fixed costs is straightforward: Total Fixed Cost ÷ Number of Units Produced = Fixed Cost per Unit. This formula shows that as production increases, fixed cost per unit decreases, which is why larger companies often have a competitive advantage.

Common Fixed Cost Items

In daily business operations, fixed costs often include:

• Office or factory rent – paid regardless of the day, whether for an office, factory, or storage, as a fixed monthly amount
• Salaries of permanent staff – full-time personnel receive a fixed salary regardless of workload
• Insurance – building insurance, asset insurance, liability insurance, etc., as annual expenses
• Other expenses such as administrative costs, membership fees, software licenses
• Interest on loans – if the company has debt, interest payments are made regularly as per the contract

Variable Cost (Variable Cost): Flexible Expenses

Unlike fixed costs, variable costs change directly in proportion to the level of production. When manufacturing increases by more than 50%, variable costs will also increase by approximately 50%, for example.

Characteristics of Variable Costs

Variable costs offer greater flexibility to managers because they can control these expenses by adjusting production levels. If market demand decreases, production can be reduced, leading to a decrease in variable costs.

To evaluate variable costs, you should use the formula: Total Variable Cost ÷ Number of Units Produced = Variable Cost per Unit. This measurement is crucial for determining the appropriate price per product to ensure profitability.

Examples of Variable Costs in Production

Variable costs often appear in operational activities:

• Raw materials and components – the more products produced, the more raw materials are needed
• Direct labor – daily workers or temporary staff paid based on hours worked
• Energy – electricity, gas, water used in production; higher production consumes more energy
• Packaging and transportation – additional packaging for increased sales
• Commissions – if sales increase, sales team commissions also increase

Analyzing Total Costs and Practical Application

Knowing fixed and variable costs separately is not enough; you need to combine both to understand the true total cost.

Cost Calculation Formula

Total Cost = Fixed Cost + (Variable Cost per Unit × Number of Units Produced)

For example, if a company has fixed costs of 100,000 THB and variable cost per unit of 50 THB, and produces 2,000 units, the total cost will be 100,000 + (50 × 2,000) = 200,000 THB.

Then, the cost per unit is 200,000 ÷ 2,000 = 100 THB per unit.

Application in Pricing

Knowing the total cost helps you set the correct selling price. The price must be sufficiently higher than the cost per unit to cover fixed costs, variable costs, and generate profit.

For example, if the cost per unit is 100 THB, you might set a selling price of 150 or 200 THB per unit, depending on the market and desired profit margin.

Main Differences Between the Two Types of Costs

Recommendations for Effective Cost Management

Reduce Fixed Costs Creatively

While some fixed costs are unavoidable, you can find ways to reduce them, such as leasing cheaper space, hiring some roles online instead of full-time, or cutting unnecessary services.

Improve Variable Cost Efficiency

For variable costs, focus on negotiating prices with raw material suppliers, improving manufacturing processes to reduce waste, and designing cost-effective transportation systems.

Analyze Break-Even Point

The break-even point is the production level where profit equals zero. It can be calculated as: Break-Even Point = Fixed Cost ÷ (Price per Unit - Variable Cost per Unit). Knowing this helps you understand how many units you need to sell to avoid losses.

Summary

Fixed and variable costs are fundamental to financial analysis in business. Understanding and calculating both types of costs enable you to make informed business decisions, from pricing and production planning to risk assessment. Systematic management of these costs will lead to profitability and sustainable growth in the long term.