Fixed costs stay the same regardless of how much you produce or sell. Variable costs change with your output. Understanding the difference is how you know which costs to cut when revenue drops and which to invest in when it's growing.
Every business has two types of costs, and they behave differently when the world changes. Understanding which is which is the difference between panicking in a downturn and executing a plan.
Fixed costs are your baseline burn - the money you need to spend to keep the lights on, even if you sell nothing next month. They're stable and predictable, but they're also a trap. When revenue drops, fixed costs stay fixed, which means they eat into profit faster. A business with high fixed costs needs high revenue to stay profitable.
Variable costs scale with your output. More sales mean more variable spending; fewer sales mean less. This makes variable costs both flexible and risky. If your business model is built on high volume at low margin, a sudden revenue drop can turn variable costs into a profitability cliff.
Most successful businesses think in terms of contribution margin - the revenue left after paying variable costs. If you know your contribution margin, you know how much each sale contributes to covering your fixed costs. This drives your pricing, your sales targets, and your cash flow forecast.
The simplest way to understand the difference is to look at what happens when activity changes.
Fixed costs don't change with output:
These costs are stable and predictable, which makes budgeting easier. But they create a hurdle: you need enough revenue to cover them before you make any profit.
Variable costs scale with output:
The proportion of variable costs to revenue stays roughly constant, which means you can predict them. If variable costs are 30% of revenue, a $100,000 month means $30,000 in variable costs; a $50,000 month means $15,000.
A comparison table:
| Aspect | Fixed Costs | Variable Costs |
|---|---|---|
| Changes with output? | No | Yes |
| Predictable? | Yes | Scales proportionally |
| Examples | Rent, salaries, insurance | Materials, commissions, shipping |
| What happens in downturn? | Stay the same, pressure profit | Drop with revenue |
| What happens in growth? | Stay the same, improve margin | Scale up with revenue |
Contribution margin example:
A consulting firm has £200,000 in annual fixed costs (salaries, office, software). On each £100,000 project, they pay £30,000 in variable costs (contractors, travel, software licenses). Contribution margin = (£100,000 - £30,000) / £100,000 = 70%.
They need to cover £200,000 in fixed costs using that 70% contribution margin. That means they need at least £286,000 in revenue to break even (£200,000 / 0.70). Every pound above that contributes to profit.
Understand what drives your variable costs. Some aren't obvious. A SaaS business might have low direct variable costs per user, but support costs rise with scale. A retail store has obvious variable costs (inventory) but hidden ones too (shrinkage, packaging waste, returns processing).
Watch your fixed cost base. It's easy to ratchet up fixed costs during good times (hiring, rent, subscriptions) and painful to cut them when revenue drops. Before adding a fixed cost, know how much revenue you need to justify it. If you're hiring someone at £40,000 a year and your contribution margin is 50%, you need an extra £80,000 in annual revenue just to break even on that hire.
Fixed costs drive your minimum viable revenue. Many businesses fail not because their margins are bad, but because their fixed cost base is too high relative to their market size. A manufacturing business with a £500,000 annual fixed cost base needs a big customer base. A side hustle with £10,000 in fixed costs might never reach break-even.
In a downturn, variable costs fall but fixed costs don't. This is the core pressure point. A 30% revenue drop means variable costs fall 30%, but rent, salaries, and loan payments are unchanged. Profit doesn't fall 30% - it falls much more. This is why business models with high fixed costs need high revenue stability to work.
Semi-variable costs exist in the real world. Your internet bill has a fixed component (the base service) and a variable component (overages). Phone contracts, power bills, and some contractor arrangements are split between fixed and variable elements. When analysing, break them into their fixed and variable parts.
Fixed costs don't change with production. Rent, insurance, salaries, and software subscriptions are fixed - you pay the same amount each month whether you do $10,000 or $100,000 in revenue. Variable costs scale with how much you sell. Raw materials, packaging, payment processing fees, and hourly contractor pay rise and fall with output. Most businesses have both.
Rent, employee salaries, insurance premiums, office utilities, software subscriptions, loan repayments, and vehicle leases. These costs exist whether you're busy or slow. A restaurant pays the same rent on a Tuesday night and a Saturday night. A SaaS company's server infrastructure is mostly fixed, even if customer numbers spike.
Raw materials, packaging, shipping, sales commissions, credit card processing fees, and hourly contract labour. These scale with production or revenue. A bakery spends more on flour when it sells more loaves. An agency pays more in contractor costs when it takes on more client work. A software company's cloud hosting can be variable if you're on a usage-based plan.
When you understand your fixed and variable costs, you can calculate contribution margin - the revenue left over after paying variable costs. This tells you how much each sale contributes to covering fixed costs and profit. If variable costs are 30% of revenue, your contribution margin is 70%. You need enough sales volume to cover fixed costs before you hit profit. This drives your breakeven point and your pricing strategy.
Not in a pure sense, but many real costs have both elements. A phone plan might be $50 a month (fixed) plus $0.10 per additional minute (variable). Electricity is partly fixed (base charge) and partly variable (usage). When analysing, split the cost into its fixed and variable parts and categorise each separately.
When revenue drops, your variable costs drop too - fewer sales means less spending on raw materials, commissions, and packaging. Fixed costs stay the same, so they become a larger percentage of revenue. This is why downturns are painful even for healthy businesses. Your fixed costs - salaries, rent, insurance - don't shrink. If revenue drops 20% but you can't cut fixed costs, your profit margin compresses fast. This is why knowing your fixed cost base matters: it tells you how much revenue you need just to stay flat.
Cost of Goods Sold is the total cost of materials, labour, and manufacturing overhead directly tied to producing goods that a business sells. It excludes indirect expenses like marketing and distribution, and is deducted from revenue to calculate gross profit.
The break-even point is the sales volume or revenue at which your business's total revenue exactly equals its total costs. Below break-even, you lose money. Above it, every additional sale contributes to profit. It's the threshold between loss and profit.