Variable costs are what cause your profits to fluctuate: A necessary guide to cost management

Imagine this scenario: a small business owner just opened a candy shop. In the first month, they sold 100 boxes, making a sufficient profit. But during the holiday season, sales skyrocketed to 500 boxes. Costs increased significantly, but profits did not scale proportionally. This problem stems from a lack of understanding: variable costs are expenses that change with the volume of production or sales, and entrepreneurs need to manage them wisely to maintain profitability.

In business operations, costs are mainly divided into two categories: fixed costs and variable costs. Understanding the difference between these two is key to financial planning, pricing, and investment decisions. This article will help you deeply understand what these costs are, their characteristics, and how to manage them efficiently.

Fixed Costs vs. Variable Costs: The Fundamental Difference Every Entrepreneur Must Know

When discussing business costs, they are typically categorized based on how they change:

Fixed costs are expenses that remain unchanged regardless of whether the business sells 10 or 1,000 units. These costs must be paid in full whether there are customers or not.

Variable costs are expenses that fluctuate with the level of production or sales. When you produce more, these costs increase; when you produce less, they decrease accordingly.

This distinction greatly impacts management decisions because fixed costs can pressure the business during low sales periods, while variable costs offer flexibility to control expenses based on operational activity.

Variable Costs Are Fluctuations of Money: Real Business Examples

To clarify, consider an online food business. When the shop receives regular orders, and customer demand increases fivefold, the owner must buy more pork, rice, and marinade ingredients. They also need to hire temporary staff, pay for delivery fuel, and purchase packaging boxes. All these are variable costs—costs that can increase or decrease depending on production demand.

Common Variable Costs

Variable costs appear when producing or selling and diminish or disappear when there are no sales. Clear examples include:

• Raw materials and components: Sugar, flour, meat, or electronic parts that need to be purchased additionally upon order.

• Direct labor costs: Wages paid to workers based on the quantity produced, such as temporary staff or piece-rate wages.

• Packaging and shipping materials: Boxes, wrapping paper, tape, which increase with order volume.

• Additional energy costs: Electricity and water usage that rise when machinery operates intensively.

• Sales commissions: Payments to salespeople based on the number of units sold.

• Payment processing fees: Transaction fees from payment gateways.

Fixed Costs That Entrepreneurs Must Pay Regardless of What Happens

Unlike variable costs, fixed costs are permanent obligations that entrepreneurs must accept, whether the market is good or bad, whether they are selling products or not.

Common Fixed Costs

• Rent: Payments for shop, office, or storage space, due monthly or annually as per lease agreement.

• Salaries of permanent staff: Fixed wages for managers, administrative staff, or full-time employees, regardless of sales volume.

• Depreciation of machinery and equipment: Annual depreciation expenses for machinery, refrigerators, or computers.

• Insurance: Building, product, or liability insurance premiums.

• Interest on loans: Fixed annual interest payments on borrowed capital.

• Licensing and permits: Government licenses or permits that require regular renewal fees.

How to Manage Variable Costs to Increase Profit Margins

Since variable costs are most controllable, managing them effectively can significantly boost profits.

Strategies to Control Variable Costs

1. Negotiate with Suppliers
Raw material costs are often the largest component of variable costs. Negotiating better prices or bulk purchasing can reduce expenses by 10-20%, directly increasing profit margins.

2. Improve Production Processes
Upgrading machinery or streamlining workflows can reduce waste and production time, lowering per-unit costs.

3. Optimize Shipping and Logistics
Consolidate orders, choose more cost-effective carriers, or optimize delivery routes to cut transportation expenses.

4. Accurate Demand Forecasting
Properly predicting sales helps avoid over-purchasing raw materials or excess inventory, reducing waste and storage costs.

5. Consider Expansion or Investment
If sales are consistently high, investing in larger or more efficient equipment can lower the variable cost per unit, making scaling more profitable.

Analyzing Total Costs for Smarter Decision-Making

Understanding how fixed and variable costs influence profit at different sales levels is crucial.

Calculating Break-Even Point

The break-even point is the sales volume needed to cover all costs, calculated as:

Break-Even Units = Fixed Costs ÷ (Selling Price per Unit – Variable Cost per Unit)

For example:

• Fixed costs = $10,000/month
• Selling price per unit = $100
• Variable cost per unit = $40

Break-Even Units = 10,000 ÷ (100 – 40) = 10,000 ÷ 60 ≈ 167 units

This means you need to sell at least 167 units to avoid losses.

Impact of Cost Changes

If you reduce variable costs from $40 to $35 per unit, the new break-even point becomes:

Break-Even Units = 10,000 ÷ (100 – 35) = 10,000 ÷ 65 ≈ 154 units

Reducing variable costs by $5 per unit allows you to reach the break-even point 13 units earlier, increasing profitability beyond that point.

Variable Costs Are the Key to Sustainable Business Management

In summary, a deep understanding of variable costs enables entrepreneurs to:

• Set appropriate prices by knowing which costs must be covered.
• Plan production aligned with market demand without waste.
• Identify areas where cost savings are possible, especially in variable expenses.
• Make informed investment decisions based on clear return estimates.
• Maintain financial stability even during fluctuating sales periods.

Variable costs allow a business to adapt quickly and manage efficiently. Mastering control over them provides a competitive advantage and paves the way for long-term success.