Create an account and get free access to 50+ articles.
Sign up for free >>
BootCamp Articles

Articles read: 0/52

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


Finish Summary

The selected solution is not correct.

The selected solution is correct.

Question 1

Question 2

Question 3

Question 4

Question 5

Retake Quiz

Do you have questions on this lesson? Pose it to our community!

Ask a question
Related case(s)

The municipal utility Hamburg Energized is a local energy retail (power and gas) and distribution grid company active in the city of Hamburg. The majority of shares of Hamburg Energized is held by the city itself. As the distribution system operator of Hamburg, Hamburg Energized is responsible for t ... Open whole case

Unified Health

Solved 18.9k times
4.3 5 2712
| Rating: (4.3 / 5.0)

Our client is Unified Health, a health care company in the US. It insures patients and provides health care services. Employers pay a premium to UH for their employees and UH covers all necessary medical costs. UH has 300,000 patients enrolled. It has 300 salaried physicians covering 6 health center ... Open whole case

Central hospital

Solved 13.4k times
4.2 5 1773
| Rating: (4.2 / 5.0)

Our client, Central hospital, is a 350-bed hospital based in a medium-sized city. The company has normally seen strong financial results with a 1-4% operating gain each year for the last five years. However, this year they are projecting a $14 m operating loss and the situation is expected to worsen ... Open whole case