The key difference is how the cost behaves when business activity changes.
Fixed Costs
Fixed costs generally remain the same regardless of the level of sales or production, at least within a normal operating range.
Examples:
- Rent
- Insurance
- Loan interest
- Salaried administration staff
- Software subscriptions
Advantages
- Predictable and easier to budget.
- Can create economies of scale because the cost per unit falls as sales increase.
Disadvantages
- Must be paid even when sales are low.
- Higher financial risk during downturns.
Variable Costs
Variable costs change directly with the level of business activity.
Examples:
- Raw materials
- Sales commissions
- Billable contractors
- Freight and courier costs
- Casual labour paid per unit or hour worked
Advantages
- Greater flexibility.
- Costs reduce when sales reduce, helping preserve cash flow.
- Lower business risk.
Disadvantages
- Less opportunity to benefit from economies of scale.
- Higher sales volumes do not necessarily reduce the cost per unit.
Semi-Variable (Mixed) Costs
These contain both a fixed and a variable component.
Examples:
- Telephone plans with a fixed monthly fee plus usage charges.
- Utilities with a fixed supply charge plus consumption charges.
- Employees with a base salary plus commissions.
Which Is Preferable?
There is no universally "better" cost structure. It depends on the business.
| Business Situation | Generally Preferable |
|---|---|
| Start-up or uncertain market | Higher variable costs |
| Seasonal business | Higher variable costs |
| Rapidly changing demand | Higher variable costs |
| Established business with predictable sales | Higher fixed costs |
| High-volume operations | Higher fixed costs |
| Businesses seeking economies of scale | Higher fixed costs |
Practical Example
A manufacturing business that owns its factory has a more fixed cost structure. Rent, rates and equipment costs continue regardless of production levels, but profits can increase significantly once sales exceed the break-even point.
Bottom Line
- Variable costs are generally preferable when flexibility and risk management are important.
- Fixed costs are generally preferable when sales are stable and the business can benefit from economies of scale.
- Most businesses operate with a combination of fixed, variable and semi-variable costs, and understanding the mix is crucial for calculating contribution margin, break-even point and profitability.
If you would like to discuss further please contact us:
McNamara & Company - Chartered Accountants, located minutes from the Melbourne CBD
www.mcnamaraandco.au/contact-us
Phone +61 3 9428 1062
Email admin@mcnamaraandco.au
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