Variable and Fixed Costs Explained

Anyone who runs a business knows that some costs have to be paid no matter how many products are sold. For example, Alex owns a shoe store. He must pay his property taxes whether he sells 20 or 200 pairs of shoes each day. Mortgage payments (payments on the loan he took out to buy his building) must be made to the bank. Fire insurance, the lease on a delivery truck, and installments on a remodeling loan are other examples of costs Alex must pay regardless of sales. Expenses that have to be paid no matter how many goods or services are offered for sale are called fixed costs.

Other types of costs change depending upon how many products are produced. These are called variable costs. Variable costs include the wages of workers or salespeople, raw materials, electric power to run machines, and the cost of maintaining inventory. If Alex decides to offer more types of shoes for sale, he will need to hire more people to stock and sell these items. Alex's inventory costs will grow as well as his shipping costs for any products that he either buys or sends to customers. These are all examples of variable costs. Entrepreneurs need to understand the important differences between fixed and variable costs and how these differences affect a firm's success. Fixed costs must be paid.

The only costs an entrepreneur has control over are variable costs. Alex may be required to pay rent for his shoe store, but he can choose how many salespeople to hire or how many products to stock. The fact that entrepreneurs can’t change their fixed costs at the present does not mean they should ignore them. Fixed costs are generally paid out of the money earned from an entrepreneur's sales. If the entrepreneur can sell more products to earn more money, the fixed costs will be a smaller part of income.  Entrepreneurs often try to increase their sales to reduce the amount of fixed costs paid per item sold. This explains why many gas stations have become convenience stores in recent years. If the owner has to pay to have a building and someone there to help customers, it doesn't cost much more to sell milk and bread, too. As the result of selling other products, total sales increase. This reduces the amount of fixed costs that must be paid out of each dollar of sales, thus increasing profit.