From the Archives: Fixed Cost vs. Variable Cost

Yesterday we talked about my favorite Lean tool, Y to X trees.  If you haven’t read it yet, go check it out.  We’ll wait.

OK, welcome back.  Today we are going to talk about one of the foundational principles of operational management, fixed costs versus variable costs.  They are the two components you will find when breaking down your costs, be they production, sales, marketing or HR.

Fixed Costs

Fixed costs are the ball and chain of the business world.  You will pay these costs week to week, month to month, year to year.  They do not change based on your level of activity.

One of the most traditional examples of a fixed cost is rent of your office space.  You will pay that cost according to your lease even if you have no business operations that month.  Conversely, you’ll generally pay that same amount if you are running at 200% capacity.

Office equipment is another fine example.  Your lease costs for laptops, printers, desks and the like aren’t likely to change month to month, regardless of how often they are used.  That’s not to be confused with consumable materials, such as paper or toner for your printer.  Those would be considered…

Variable Costs

These are costs that will change based on your level of activity (or some other business variable).

In the manufacturing world, variable costs are often tied to the number of widgets produced.  If your factory is creating a physical product, there is some level of raw material used.  If we assume $1 of steel is needed to make a $2 widget, then I’ll need $100 of material for 100 items, $200 for 200 items, and so on.  Your cost will vary based on activity level, but is still predictable based on your business plans.

Another variable cost is labor.  Let’s assume I employ 10 hourly workers at $10 per hour, 40 hours per week each.  My simple cost of labor is $4,000 per week.  And at capacity, they produce 1,000 widgets.  My material cost is $1,000, bringing my operation cost to $5,000 that week.  Simplified, of course.

But if my orders increase, now we pay overtime.  For 2,000 items to be produced, I double my cost of materials.  And I need my team to work 80 hours this week at overtime rates of $15 per hour over 40.  Material is now $2,000, labor is now $4,000 for the first 40 hours, plus $6,000 for the second 40, bringing cost of operation to $12,000.  My output has doubled, but my costs have increased even more based on the change in production level. My lease on the factory, though, will have remained the same.

Fixed vs Variable Costs in HR

These are simple concepts, at least at this level.  The application can become complex, but the point here is to try to identify the difference.

HR, of course, has both types of cost as well.  A few examples:

Fixed costs: equipment lease, exempt salaries, ATS contract rates

Variable costs: job postings, applicant materials, travel

There are plenty of other examples of course.  Tomorrow, we will take a look at how these two costs can be combined with our Y to X tree to start identifying action plans from strategic goals.

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