What you’ll learn

  • What fixed and variable costs are
  • The difference between variable costs and fixed costs
  • How fixed and variable expenses affect your business and budget

Cash flow determines your ability to meet short-term financial obligations aka not run out of money. In order to successfully manage cash flow, you need to accurately predict how much money is leaving your business on a month-over-month basis. That means you need to know the difference between fixed and variable costs. 

Fixed Cost: A constant expense that your business incurs regardless of the level of output. Examples can include rent, business insurance, and loan repayments.

Variable Cost: An expense that your business incurs, either regularly or not, which can fluctuate and adjust as your company grows. Examples include salaries, distribution expenses, and credit card fees.

Being able to forecast and categorize these costs will help you keep a healthy cash flow for your business and make more informed decisions about how to spend your money.

What are fixed costs?

Fixed costs are expenses that remain the same regardless of how many goods are sold or hours of service are provided by your business. Often referred to as “overhead”, these costs are necessary to keep a business running but don’t directly contribute to the production of merchandise or services being sold.

Common fixed cost categories include:

  • Rent or lease payments
  • Employee salaries and wages
  • Insurance costs 
  • Property taxes

An easy way to tell if an expense should be categorized as fixed is to consider whether the cost would be the same even if the business temporarily shut down. For example, if a business were to close for a month, the rent on their storefront or office would still need to be paid.

How do fixed costs impact business?

Let’s say you need to pay $2000/month for an office space where your team of copywriters can work. Knowing that you’ll need the space at least for the next 12 months, you can slide that expense into the “fixed cost” column of your budget for the upcoming year. Even if you shut down for a month or hire 4 new employees, that recurring expense will stay the same every month.

Fixed costs tend to represent a large portion of your business expenses and are sometimes difficult to reduce. They can have a big impact on your bottom line since they don’t fluctuate based on the level of output. If your business has high fixed costs and low sales, it may struggle to break even or be profitable. 

What are variable costs?

Unlike fixed costs, variable costs are expenses that fluctuate based on the output of your business. These costs are directly tied to the products or services being sold and tend to increase as the level of output increases.

Common variable cost categories include:

  • Raw materials
  • Commissions
  • Packaging & Shipping
  • New equipment

A company can best categorize variable costs by applying the opposite logic to fixed costs.  Consider whether the cost would change if you started selling more or less of your product or service.

For example, if an event marketing agency were to host 15 more events this year than it did last year, it would likely need to buy more equipment, contract more vendors, and book more venues. Their monthly event costs would go up overall and fluctuate month-to-month based on how many events they hosted. 

How do variable costs impact business?

Since variable costs increase or decrease based on the level of output, they can be challenging to plan for with precision. Having too many variable costs might make managing your cash flow more difficult. Ideally, small business entrepreneurs should try to forecast variable costs as accurately as possible and budget accordingly to withstand dips and spikes in expenses. 

The good news? Because variable costs tend to be more flexible than fixed costs, they can be easier to reduce if you need to. For example, if a business experiences an increase in sales, it may be able to increase production and reduce the unit cost of its products by taking advantage of economies of scale. 

How to reduce variable costs

Identify which variable costs are necessary for the business to operate effectively and which ones may be able to be reduced or eliminated. Once you identify the best options for reduction or elimination, try these strategies: 

  1. Invest in automation. Eliminating or reducing labor hours means less overhead and variability. Automation can be set and categorized as fixed costs.
  2. Negotiate discounts. When dealing with a vendor, try negotiating a discount. If you know you’ll have a recurring variable expense, do your best to lower the rate.
  3. Budget proactively. Variable costs are easier to manage if you can forecast them with plenty of warning. Give yourself enough time to negotiate the best price and set aside cash for the additional expense. 
  4. Reduce waste. Inefficient operations create unnecessary drag and can put your business in a position where variable costs go up due to poor planning. Streamline your operations so you don’t have to make costly last-minute decisions. 

Fixed costs vs variable costs

Fixed costs and variable costs can have a significant impact on the profitability of your business. Visualizing the differences between these two types of costs can help better understand how they impact your business.

Why is it important to differentiate and track costs?

Confidence in your cash flow makes it easier to make decisions on hiring, purchases, and critical business functions like:

  1. Pricing your products and services effectively.
    1. Once you understand fixed and variable costs, it will illuminate what you should be charging for your products and/or services to become profitable. In business, this often gets referred to as a break-even analysis.
  2. Forecasting your cash flow accurately.
    1. Forecasting your cash flow requires an intimate understanding of which costs are fixed and which are variable. The more accurate your data on fixed and variable costs, the more accurate your cash flow forecasts will be. 
  3. Updating your budget when needed.
    1. If you’ve achieved a company milestone and want to work toward fresh goals, you might be ready to reassess your fixed costs, variable costs, and profit.

Effortlessly manage your cash flow with Hopscotch

One effective way to improve your company’s cash flow? Get paid on time. With Hopscotch, you can easily submit and track invoices, pay bills, and integrate with Quickbooks to automatically reconcile payments. Sign up for a free account today.