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📖 Chapter 3 (Part 3): Fixed Costs vs Variable Costs – How They Affect Profitability
🔹 Introduction
Every company spends money to run its business — salaries, rent, electricity, materials, and more.
But not all costs behave the same way. Some stay constant; others change as production increases.
Understanding Fixed Costs and Variable Costs helps investors analyze a company’s profitability and stability — two key pillars of fundamental analysis.
Fundamental analysis series – click here
🔹 What are Fixed Costs?
Definition:
Fixed costs are expenses that do not change with production or sales levels.
Even if the company makes zero sales, it still has to pay these costs.
✅ Examples:
- Factory rent
- Employee salaries
- Insurance
- Equipment depreciation
Example:
A car company pays ₹10 lakh/month for factory rent — even if it produces 1 car or 1,000 cars, rent stays ₹10 lakh.
🔹 What are Variable Costs?
Definition:
Variable costs are expenses that change with production or sales volume.
If the company produces more, variable costs rise; if less, they fall.
✅ Examples:
- Raw materials
- Packaging
- Shipping & delivery costs
- Electricity usage (based on production)
Example:
Each car requires ₹5 lakh worth of materials.
If 100 cars are made → Variable Cost = ₹5 lakh × 100 = ₹5 crore
🔹 Simple Formula
📘 Total Cost = Fixed Costs + Variable Costs
This total cost decides how much profit a company will make at different production levels.
🔹 Why This Matters for Investors
- Break-Even Point
- The number of units a company must sell to cover all costs.
- Beyond this, every sale adds to profit.
- Operating Leverage
- Companies with high fixed costs benefit more from rising sales (profits grow faster).
- But if sales fall, losses hit harder.
- Business Stability
- Low fixed costs = more flexibility during slow demand.
- High fixed costs = risky in downturns but powerful in booms.
🔹 Real-Life Examples
| Company | Fixed Cost Heavy | Variable Cost Heavy | Comment |
|---|---|---|---|
| Airlines (IndiGo) | ✅ (Planes, fuel, salaries) | Moderate | Profits rise fast when seats filled; losses big when empty |
| DMart | ✅ (Store rent) | Moderate | Stable model but dependent on volume |
| Zomato | ❌ (Platform) | ✅ (Delivery cost per order) | Low fixed cost, scalable model |
| ITC | Moderate | Moderate | Balanced business with stable margins |
🔹 Analogy: Tea Stall Example 🍵
- Fixed Cost: Stall rent ₹5,000/month
- Variable Cost: Milk, sugar, gas per cup ₹5
If you sell 1,000 cups at ₹10 each →
- Revenue = ₹10,000
- Variable Cost = ₹5 × 1,000 = ₹5,000
- Fixed Cost = ₹5,000
- Profit = ₹0 (Break-even point)
If you sell 1,500 cups → extra 500 cups become pure profit after variable cost.
🔹 Investor’s Viewpoint
- High fixed costs → more risk in bad times, more profit in good times.
- High variable costs → stable margins, less profit swings.
- Smart investors prefer companies that maintain a healthy balance.
🔹 Q&A Section
Q1: Which type of company is better for long-term investment?
A: Those with manageable fixed costs and scalable variable costs.
Q2: Can fixed costs ever change?
A: Yes, but rarely — e.g., new factory lease or expansion.
Q3: Why do startups prefer variable cost models?
A: To reduce risk — they pay only when they earn.
Q4: How to check company cost structure?
A: Look at the annual report under “Expenses” or “Operating Margin” section.
🔹 Key Takeaways
- Fixed Costs: Stay constant regardless of output.
- Variable Costs: Change with production/sales.
- Together, they decide profitability, risk, and scalability.
- Companies with balanced cost structures perform well long-term.
- Always analyze cost behavior before investing.