The Difference Between Fixed and Variable Costs
Types of Costs:
In the simplest of terms, variable costs are associated directly with the sales of a product or service and therefore increase and decrease as the amount of sales increases and decreases whereas fixed costs remain the same regardless of the amount of sales. For foodservice, variable costs are the costs of raw materials, labor costs associated with fulfilling sales, and any SG&A costs directly associated with sales like for example sales commission for product sales. Fixed costs are the things that stay the same regardless of how much is sold: manager’s salaries, rent, utilities, etc.
Once you start to dissect each of these costs however, they all have a variable and fixed component.
Let’s look at utilities for example; yes, we need to keep the lights on regardless of how much food we are selling. In this instance, the electric bill is then a fixed cost- the lights are on every day for 12 hours no matter what. However, let’s say we double sales, our electric bill will almost certainly go up as we have more employees using electronics, our equipment is being run more during the day, and our daily shifts are now 14+ hours. Does this make utilities a variable cost? It is tempting to say yes, since we have just proven that utilities will change as the amount of product produced and sold changes. However, I will argue that it is still a fixed cost but what is changing in the second scenario is your cost structure. Put another way, we have changed your capacity constraint, or the amount of sales that you can achieve with a certain set of fixed costs.
Let's Look at An Example of Capacity Constraint:
If we are producing somewhere between 800-1,000 units/month it is likely that our electric bill stays the same. Our shifts run exactly the same, we run the equipment the same. So at 800 units the electric bill is the same as it is at 1,000 units. But what happens when we need to produce 1,400 units in a month? This is the level at which we need to hire more employees, add more workstations, and run 14 hours shifts every day. Now we will see our electric bill increase. What this example shows is that our original cost structure, with the fixed electric bill, is only pertinent until we make 1,000 units. That is our capacity constraint.
Beyond 1,000 units our cost structure changes meaning that our fixed costs have to adjust to support and new level of capacity. Not only is there a different base level of electricity, but our base staffing levels changed, we needed more workstations, our shifts had to be longer, etc. And this new cost structure would also have a capacity constraint. Perhaps we could produce 1,600 units with a 16 hour shift but if we want to produce 2,000 units in a month we would need to move to a bigger facility.
Cost structure determines what happens on your financial statements before you produce a single unit of salable product.
Why it Matters:
It is important to identify your capacity constraint and the associated cost structure that you are working within so that you understand where your ceiling is for current sales and at what point you will have to invest more into fixed costs if you want to continue to grow. In this example it is possible that I am more profitable at 1,000 units than I am at 1,001 because I have reached my potential at 1,000 with a lower fixed cost structure whereas at 1,001 I am making the bare minimum at a higher cost structure. Additionally, if we scaled up to produce 1,400 units a month for 2 months, but then sales returned to 1,000 units per month after that it can be difficult to change the cost structure again at least in the short term.
Capacity constraints exist and while they can be changed in the long run they are pre-determined in the short-run. Understanding your cost structure is an important step in maximizing your profitability.