Fixed and Variable Costs

What are fixed and variable costs?

Fixed and variable costs (German: Fixkosten und variable Kosten) are the two basic types of cost, distinguished by whether they change with the quantity sold or produced. Fixed costs stay the same over a given period, regardless of whether a company sells more or less; examples are office rent, administrative salaries and insurance. Variable costs rise and fall with the quantity, such as materials, purchased goods, shipping or sales commissions. In a launderette, the shop rent and the leasing instalments for the machines are the same every month, no matter how many customers come; electricity, water and detergent grow with every load.

The distinction comes from internal cost accounting, not from the annual financial statements. The profit and loss account under the German Commercial Code (Handelsgesetzbuch, HGB) classifies expenses by type, such as cost of materials and personnel expenses, or by function, such as production and sales, not by their behaviour. The usual business management evaluation (Betriebswirtschaftliche Auswertung, BWA), the monthly report from financial accounting, does not separate them in this way either. Companies therefore make the separation themselves, usually in the financial model. Investors read from it how much more profitable a business model becomes as revenue grows, and buyers read the cost base they are taking on.

Difference between fixed and variable costs

"Fixed" always applies only for a period and within a capacity, that is, the quantity that can be handled with the existing employees, premises and equipment. In the long run, every type of cost can be changed. Within these limits, total costs are made up of both types:

Formula: Total costs = fixed costs + variable cost per unit × quantity

For planning, four forms of cost behaviour have to be distinguished.

Variable costs

Variable costs arise per unit sold. Per unit they usually stay the same, while in total they grow with the quantity. Volume discounts can reduce the cost per unit as the quantity grows.

Fixed costs

Fixed costs stay the same in total, but per unit they fall as the quantity rises. This fixed cost degression is the reason why growing companies with a high share of fixed costs become more profitable: the same rent and the same development team are spread over more revenue.

Step-fixed costs

Step-fixed costs are constant within a capacity level and jump as soon as that level is exceeded. Typical cases are an additional support employee for each given number of customers, a second warehouse or a further shift in production.

Mixed costs

Mixed costs contain a fixed and a variable part. Examples are electricity with a base price and a consumption price, a sales salary with a fixed salary and commission, or a cloud contract with a minimum purchase and a usage-based surcharge.

Cost structure by business model

• Software: high fixed costs for development, sales and administration, low variable costs per customer, mainly for server operation and payment processing. Each additional customer contributes almost entirely to covering the fixed costs, but high losses can arise until the break-even point.
• Services and consulting: personnel is the largest cost block. Permanently employed staff cause costs that behave like step-fixed costs; freelancers and subcontractors are variable. Utilisation, that is, the share of billable hours, decides the result.
• Retail and e-commerce: a high variable share through cost of goods, shipping, payment fees and advertising costs per order. The result reacts less strongly to revenue fluctuations, but the margin per sale is thin.

Operating leverage and break-even point

If the variable costs are deducted from revenue, the result is the contribution margin. It is available to cover the fixed costs; what remains afterwards is the operating result, that is, the result of the ongoing business before interest and taxes. The break-even point is reached when the contribution margin just covers the fixed costs. The margin of safety shows by what percentage revenue lies above this threshold.

Formula: Break-even quantity in units = fixed costs divided by (price per unit minus variable cost per unit)

Operating leverage describes how strongly the operating result reacts in percentage terms to a change in revenue. It can be calculated as the contribution margin divided by the operating result and equals the reciprocal of the margin of safety. The closer a company operates to the break-even point, the greater the leverage. A value of 3 means that a revenue increase of 10% raises the result by 30%. The leverage works in both directions: companies with a high share of fixed costs lose disproportionately when revenue falls. The calculation applies only up to the next capacity limit.

How quickly costs can be reduced

Costs generally rise faster than they can be cut again. This delay is called cost stickiness (Kostenremanenz). It is based mainly on contractual commitments:

• Employment contracts: The statutory notice periods under Section 622 of the German Civil Code (BGB) lengthen with the period of service when the employer gives notice. From a certain company size, the German Protection Against Dismissal Act (Kündigungsschutzgesetz) also applies, and severance payments may be added.
• Commercial leases: They are usually concluded for a fixed term, during which ordinary termination is excluded.
• Software, leasing and service contracts: Minimum terms, minimum purchases and automatic renewals often bind for years.

An overview of all larger cost blocks with term, notice period and exit costs shows which part of the fixed costs can actually be influenced in three, six or twelve months.

Significance in funding rounds and company acquisitions

Funding round

Investors check whether the variable costs per unit stay stable or fall with growth and whether the fixed costs grow more slowly than revenue. Together, these make up the scalability of a business model. The monthly burn rate, that is, the ongoing consumption of liquidity, consists predominantly of fixed costs in growth companies. Investors therefore ask how quickly the costs can be adjusted if revenue falls short of the plan.

Company acquisition

In a company acquisition, the cost savings from the combination (synergies) are predominantly fixed cost synergies: duplicate administrative functions, locations and systems fall away. Variable costs fall mainly through better purchasing terms. In the detailed review by the buyer (due diligence), its advisers evaluate the contract terms for this purpose. They look for clauses that give contractual partners a right of termination if the majority shareholder changes (change of control). Finally, the buyer adjusts the cost base for items that fall away or arise anew after the sale.

Worked example: fixed costs, variable costs and break-even point

A company sells a product at EUR 50. Per unit, variable costs of EUR 30 arise for materials, shipping and payment fees. The fixed costs for personnel, rent and software amount to EUR 300,000 a year. 20,000 units are sold.

• Revenue: 20,000 × EUR 50 = EUR 1,000,000
• Variable costs: 20,000 × EUR 30 = EUR 600,000
• Contribution margin: 1,000,000 minus 600,000 = EUR 400,000, i.e. EUR 20 per unit
• Operating result: 400,000 minus 300,000 = EUR 100,000
• Break-even point: 300,000 divided by EUR 20 = 15,000 units, which corresponds to EUR 750,000 in revenue
• Margin of safety: (1,000,000 minus 750,000) divided by 1,000,000 = 25%
• Operating leverage: 400,000 divided by 100,000 = 4, i.e. the reciprocal of 25%
• Quantity plus 10% to 22,000 units: contribution margin EUR 440,000, result EUR 140,000, i.e. plus 40%; fixed costs per unit fall from EUR 15.00 to EUR 13.64
• Quantity minus 10% to 18,000 units: contribution margin EUR 360,000, result EUR 60,000, i.e. minus 40%
• Step-fixed costs: From 24,000 units an additional warehouse is needed, costing EUR 60,000 a year. At 25,000 units: contribution margin EUR 500,000 minus fixed costs EUR 360,000 = EUR 140,000

The result means that every change in revenue feeds through to the result fourfold, upwards and downwards. A fall of a quarter of today's quantity would bring the company exactly to the break-even point. At the same time, the capacity step shows that growth from 22,000 to 25,000 units initially brings no additional profit, because the new warehouse completely absorbs the additional contribution margin.

Distinction: direct costs, overheads and gross margin

• Direct costs and overheads: distinguish costs by whether they can be attributed directly to a product, not by their behaviour. Direct costs are mostly variable, but not always; an annual licence for a specific product is directly attributable and yet fixed.
• Gross margin: deducts the cost of sales. These are predominantly variable but often also contain fixed parts, such as a permanently employed support team.

Common mistakes

• Classifying personnel across the board as fixed. Commissions, bonuses, overtime and freelancers behave as variable or step-fixed. Anyone who plans them as fixed underestimates the costs during growth.
• Capacity steps not planned. A financial model that projects fixed costs forward linearly overlooks additional locations, management levels or systems that become necessary from a certain size.
• Full cost per unit as the price floor. In the short term, a price only has to cover the variable costs. Anyone who uses allocated fixed costs as the floor turns down orders that would deliver a positive contribution margin.
• Mixed costs not split. If mixed costs are treated entirely as fixed or entirely as variable, the contribution margin is wrong, and with it the break-even point.

Frequently asked questions

Are personnel costs fixed costs?

Predominantly yes, at least in the short term. Salaries of permanently employed staff are incurred regardless of the quantity. Over longer periods, however, they behave as step-fixed costs, and performance-related components such as commissions are variable.

Are marketing costs fixed or variable?

That depends on the form of payment. A fixed budget for trade fairs or brand campaigns is fixed for the period. Advertising that is billed per click or per order and continuously adjusted to sales, by contrast, is treated as variable costs by many online retailers.

How can fixed costs and variable costs be calculated from total costs?

From two cost levels at different quantities. The variable cost per unit is the difference in total costs divided by the difference in quantities; the fixed costs are the total costs minus variable cost per unit times quantity. With total costs of EUR 420,000 for 4,000 units and EUR 500,000 for 6,000 units, this gives 80,000 divided by 2,000 = EUR 40 per unit and 420,000 minus 4,000 × 40 = EUR 260,000 in fixed costs. This applies only if there is no capacity limit between the two quantities.

Is a high share of fixed costs good or bad for investors?

Neither. A high share of fixed costs with low variable costs promises strong earnings increases with growth, but increases the risk if revenue fails to materialise. What matters is whether the liquidity lasts until the break-even point.

The Roemer Capital view

In financial planning for clients, we classify every cost block by its behaviour and record the terms and notice periods of the most important contracts. In the cautious case of the financial model, this makes it possible to show honestly which costs fall in which period if revenue declines, and which do not. Investors thus see that the plan can withstand a deviation from the base case.

In company sales, we document the cost base so that a buyer can take it on without further questions. This also allows us to check the basis of a buyer's synergy assumptions and to take them into account in the purchase price negotiation.