Definition
Fixed costs are the money that goes out no matter how much you make or sell, even if you do nothing. Variable costs are the money that rises or falls in step with how much you produce or sell. Nearly every cost of running a business or a household falls into one of these two groups.
Two Kinds of Costs at a Street-Food Stand
Imagine you've started a street-food stand selling fish-shaped pastries. Whether a hundred customers show up in a day or not a single one does, some money is due every month. It's the fee for your spot and the rental on your cart. Costs that stay the same no matter how much work you do are called fixed costs.
On the other hand, some things you have to buy more of as more customers come. Batter, sweet red bean filling, paper bags for takeout. Baking a hundred pastries costs ten times as much batter as baking ten. Costs that change with how much you produce are called variable costs.
Even if you close up for the day, fixed costs keep draining out. Variable costs, though, drop to zero when you stop working. That's why, when you run a business, it's very important to know exactly which of the two groups each payment from your account belongs to.
Who Is More at Risk in a Downturn?
A business heavy on fixed costs and one heavy on variable costs hold up very differently in a crisis. Say an owner buys expensive machines and sets up an automated factory. Labor costs are low, but every month there's a huge equipment lease to pay. This is a business with a high share of fixed costs.
When fixed costs are high, you make a lot of money while customers are pouring in. The machines are already paid for, so making one more item costs relatively little (materials and so on). But when the economy turns and orders suddenly stop, things get dangerous fast. Even if you sell nothing, a big fixed bill still eats your bank account every month.
By contrast, a small restaurant that calls in staff only when needed and spends mostly on ingredients can cut its grocery shopping when customers thin out, and ride it out. The smaller your fixed costs, the more of a safety valve you have for handling a downturn flexibly.
To Be More Precise: No Cost Is Fixed Forever
To be more precise, whether a cost counts as fixed or variable depends on the length of time you look at. In the short run, a shop's rent or a full-time employee's salary looks fixed. If business is slow, you can't cut tomorrow's rent or let someone go on the spot.
But look at a longer stretch, say one year or three, and the story changes. When the contract ends, you can move to a smaller space and lower the rent, and you can hire more people or fewer. Over a very long time, almost every fixed cost turns into a variable cost.
Many costs are also mixed, like electricity or water, where a base fee is stacked with a charge for what you use. So when you make a financial plan, don't try to sort costs into two neat boxes. Ask how quickly each one can be cut.
Common misconceptions
Labor cost is always a fixed cost (or always a variable cost).
It depends on how people are employed. A full-time salary with a set monthly base pay is close to a fixed cost. But the hourly wage of part-timers brought in according to order volume, or performance bonuses paid according to sales, count as variable costs.
Where you meet it
In a phone plan, the base fee is a fixed cost, while the extra charge for data after you use up your included data is a variable cost.
A gym membership is a fixed cost that goes out every month whether you go or not, while the protein drink you buy after a workout is a variable cost.
In one sentence
Fixed costs are steady money that goes out even when you do nothing, and variable costs are money that grows with the work you do.