Fixed & Variable Costs: Adding Flexibility to your Business Model

In Economics, there are two basic types of costs (or expenses) associated with running a business: Fixed and Variable.

Fixed costs are those that do not change with the level of business, while variable costs fluctuate with the level of business.

For instance, in a brick-and-mortar retail store, rent is a fixed cost. This is true even if rent increases by 5% per month. It is a fixed cost because, assuming everything else is the same, it won’t change depending on whether that store sells 5 widgets or 500.

In the same retail store, the costs of the widgets are a variable cost. This is so because if the store buys 5 widgets, it will spend less money than if it buys 500. So, if business is good, and the store can sell 500 widgets, it will see its costs increase accordingly.

Why is an understanding of these costs, especially variable costs, important?

Because a business model that has a higher proportion of variable costs is more flexible in a downturn. The retail store can’t cut its rent, but it can cut the number of widgets it buys. So variable costs act as cushions during recessions.

This is also important because variable costs can be indirect, and can be difficult to calculate, and thus can actually end up overtaking the revenue associated with the increase in business and lead to losses.

For instance, the profit margin on widgets might be so slim that it would take 200 widgets a month to cover the costs associated with an employee. But, it may be necessary to hire an employee for every extra 100 widgets sold in a month.

The costs associated with the extra employee may be in the form of taxes, insurance, time, etc. and may not be obvious; whereas the extra revenue from the extra widgets sold is obvious and easily calculable. So, the retail store may find itself with excellent, and growing, revenues, but still forced to close its doors.

Such a business model is broken, but not necessarily irreparably: If widgets operate in an “Economy of Scale,” then at a certain point, the expansion pays off. “Economies of Scale” are situations where ordering more of something decreases the per-unit cost of that something. For instance, ordering 50 widgets may cost $50, but ordering 100 widgets may only cost $90. The purchase order on the 100 widgets is more, but it’s 10% cheaper on a per-widget basis, which is how the retail store sells its widgets.

It is obvious how this affects variable costs: at 10% more profit per-widget, the store only needs to sell 180 widgets per month to cover the costs of the extra employee.

In other words, the retail store will lose money and not be a viable business until it is able to exploit the “Economy of Scale” on widgets and get its per-unit variable cost in line with its per-employee variable costs.

Invariably yours,
Aaron