Fixed-cost vs variable-cost: A simple guide to budgeting and pricing

Introduction

Costs come in different shapes. In business budgeting and pricing, it's useful to separate costs that stay the same from those that move with activity. This distinction helps with forecasting, pricing decisions, and risk planning.

What are fixed costs?

Fixed costs are expenses that do not change with the level of output in the short run. They must be paid even if you produce nothing. Common examples include rent, certain salaries, insurance, and depreciation on equipment.

Examples of fixed costs

• Rent or lease payments
• Salaries for office staff
• Insurance premiums
• Depreciation of equipment
• Loan payments

How fixed costs affect decisions

Because fixed costs are constant, adding more units can spread these costs over more output, lowering the average cost per unit as volume rises—up to the limit of the relevant time frame.

What are variable costs?

Variable costs change in proportion to the level of production or activity. If you produce more, you incur more of these costs. Per unit, these costs are called the variable cost per unit.

Examples of variable costs

• Raw materials or ingredients
• Direct labor tied to production
• Sales commissions
• utilities tied to production or usage
• Packaging per unit

The per-unit view

Variable costs per unit can stay constant in theory, but in practice they may vary with scale, supplier terms, or bulk discounts.

Key differences at a glance

• Fixed costs do not vary with output within a given period; variable costs do.
• Total cost = fixed costs + total variable costs; average cost per unit changes with volume.
• Break-even point depends on fixed costs and the per-unit contribution margin.

Examples in business contexts

In a cafe, rent and salaries are largely fixed; coffee beans and cups are variable with customer volume. A startup with high fixed costs needs enough sales to cover those costs before making a profit.

Why this distinction matters

Understanding fixed vs variable costs helps with budgeting, pricing, and risk assessment. It informs decisions about scaling, outsourcing, and when to invest in capacity.

How to analyze costs in budgeting

1. List costs and classify as fixed or variable for the relevant period. 2) Estimate expected volume and calculate total fixed costs and total variable costs. 3) Compute the break-even point and run scenario analyses for different volumes. 4) Use the results to guide pricing and capacity planning.

Takeaways

• Distinguish fixed and variable costs to understand how total costs behave as activity changes.
• Use this view for budgeting, break-even analysis, and pricing decisions.