# Fixed and variable costs are a crucial part of a financial analysis

## Determine fixed and variable costs to better understand your cost structure

You should be aware by now of the profitability framework in which we calculate **profits by subtracting costs from the revenues** of the business.** **In order to understand the underlying cost structure, it is important to **segment or break down the costs. **In most cases, costs can be broken down into **fixed and variable** costs because these components differ in **two major dimensions**: business activity independent and time dependent.

**1) Business activity independent:**

**Fixed costs** are the costs that occur on a regular basis including rent, administrative costs, depreciation and salaries, and are independent from the level of activity (e.g., production). On the other hand, **variable costs **are directly** connected to the activity **such as raw materials, energy, temporary labor costs or leased employees needed to manufacture a product. The schematic below shows roughly how the total costs increase with the number of units (or product quantity). This information is often useful to "price" a product.

**2) Time-wise adaptability**

**Variable costs **can vary and are dependent on time since they are directly related to the manufacturing of the products. Note that, if you extend your time frame, all costs including fixed costs become variable in theory. Why? Because you can find "better deals", high rent *vs*. low rent or high salaries *vs*. low salaries.

## High/low fixed and variable costs usually have different implications

High fixed cost businesses are highly dependent on high volume sales to make profits (e.g., airline industry). For example, if you have an **airline with high fixed** costs and low consumer **demand**, you will likely suffer losses. On the other hand, **low fixed costs **comes with low risk of volatile consumer demand but also comes with limited growth opportunities and a risk of significant cost increases with sudden increase in demand. Additionally, lower fixed costs are an incentive for competitiors to enter the market more easily (low barriers to entry). Thus, keeping these consequences in mind is important while solving a case that involves businesses with extremely high/low fixed/variable costs.

## The concept of fixed and variable costs can be deployed in various case settings

In a case interview scenario, assume your client in the case would like to build a **new production facility** which has **high fixed costs **and therefore needs a **high utilization** in order to be profitable. Knowing that the **utilization is primarily driven by demand, **you are asked to figure out if this is a good idea. You can analyze the case as discussed in the following section.

Logically, you know that if a **competitor** also builds a **new plant**, the demand for your client's products will decrease. Therefore, given the facts, you will need to structure and then **analyze the market, **the **competitors **and the** cost structure** using the concept of fixed and variable costs. In a case interview, business situations that could include such considerations are cases related to Pricing, Market Entry or, Growth Strategy.

It might be useful though to consider the opportunity cost as well. If the company takes this order it must forego any new orders above 2000 units as it almost reaches capacity. So when comparing this order to the same order at the "normal" price of 14$, the company could make an additional profit of $25,000. Comparing this with the $10,000 in profits the company can make by taking this order, it is left with a $15,000 loss. Accordingly, when taking OC into account, option d is valid as well.

The chance of receiving another order to the "normal" price is to be debated and should probably be taken into account as well.

Another way to think about the calculations in question 2, is that the second order occurs in addition to the first order, so no need to again subtract the fixed cost. So what you are left with is the revenue of the order minus (VC*units); which is $10k.

Hi Sila, in your calculations you combined the first (domestic) order with the second (new international) order. However, you need to forget about the profit of the first domestic order, because they only ask how much profit or loss the new order brings in.

If you calculate them separately you get:

First order: Profit = Revenue - Cost --> 5.000*14 - 5000*9 - 20 000 = 70 000 - 65 000 = 5 000 profit (but you should not take this profit into consideration, since the total profit of the orders combined is not asked here. Just the new order, given that you don't have any fixed costs anymore for the second order.

Second order: Profit = R - C --> 5000*11 - 5000*9 - 0 = 55 000 - 45 000 = 10 000 (which is the answer here)

Indeed if one would want to know the overall profit or loss including both orders, you would get your answer: [first order p/l] + [second order p/l] = 5 000 + 10 000 = 15 000

Hope this answers your question.

Hi!

In question 2, I have a problem with the solution. Since there are 5000 units being sold at $14 and 5000 units to be considered to be sold at $11, it makes $125 000 revenue per year. And, $20 000(FC) + $90 000 (VC: $40 000 for LC and $50 000 for RawC) makes $110 000 total cost. When I substract $110 000 from $125 000, I get $15 000 profit, isnt it? But the answer is $10 000 profit. What am I missing to consider?

Thanks in advance!

I agree with you, the variable cost line shows how the costs add up over the increase of units. Per unit, the variable costs are always the same because the costs increase linear with the units.

It's also useful to figure out if the main cause of costs are fixed or variable. Use the 80/20 rule and focus on the biggest cost drivers.

I believe that the "Variable cost" line should be named "Total Variable cost" because one may interpret the current "variable cost" line as been shown on a per unit basis. Then this would clearly be incorrect.