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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.

The price of the fixed cost does not change with the amount of units. They are always the same. The variable costs depend on the units produced. If no units are produced, the variable costs are zero. Both fixed cost and variable cost add up to the total cost.

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.

Apply the concept of fixed/variable costs and solve retirement homes

Related exercise(s)

Fixed and Variable Costs – Test Your Knowledge

Fixed and variable costs are a crucial part of a financial analysis. Are you able to understand any given cost structure?

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