Fixed Costs and Variable Costs: what are the differences?



Imagine you are running a lemonade stand. To run your business, you need to know two things: the fixed costs and the variable costs associated with your product.

What is a fixed cost?

A fixed cost is an expense that is independent of sales volume.

For your lemonade stand, the fixed costs are rent, wait staff salaries, advertising, electricity, phone bill, etc. To schematize, all these charges at the second level of the income statement. Let's say your fixed costs are sixty francs a day. On your first day on the job, it doesn't matter if you sell a glass of lemonade or a hundred: the fixed costs won't change. In reality, in practice, the fixed costs increase step by step. In addition, fixed costs are often referred to as overheads or ACEs (other operating expenses).

Of course, if you decide to open a second booth on your second day, your fixed costs will change.

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What is a variable cost?

Variable costs are the costs that increase as you produce and sell more units.

In other words, it is what you should buy-in larger quantities if your business is successful. For each glass of lemonade, these variable costs will be three deciliters of water, two ice cubes, a dose of lemon juice, a tenth of a glass of white sugar, a recyclable cardboard glass that the customer keeps as well as a minute of working time.



Your variable costs totaled 35 cents per unit. Unlike your fixed costs, when you sell more lemonade, your variable costs increase proportionately.

Depending on the industry, you will have big differences between fixed and variable cost levels. For example, if you are active in e-book distribution, whether you are selling a book or 1 million books, the variable costs are theoretically non-existent. You would probably only have a minimal additional cost for electronic data transfer costs. This would be quite different if it were an online physical book sale where a tangible good is delivered to you by mail. If that same book were sold in bookstores, then there would not only be variable costs associated with the physical book, but also substantial fixed costs such as store and warehouse rent, heating, vendor salaries, security, etc.

Back to our lemonade stand. If you don't do an analysis of your fixed and variable costs, you may be selling lemonade all-day without making a profit.

Now you know how to identify fixed costs from variable costs. Thus, you can decide on a sale price, commercial objectives to achieve, or to start an entrepreneurial activity or not.

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