Understanding the cost structure of a business is crucial in profitability and operations cases. In particular, you’ll often be asked to distinguish between fixed costs and variable costs, and explain how economies of scale affect profitability as volume grows.
This article breaks down the definitions, business implications, and common case interview prompts related to these concepts.
1. Fixed vs Variable Costs
- Fixed costs: Do not change with production volume (e.g., rent, salaries, insurance)
- Variable costs: Change with each unit produced (e.g., raw materials, packaging, shipping)
“If a company makes no products, it still pays fixed costs. Variable costs only exist when production happens.”
2. Visualizing Cost Behavior
Imagine a graph with units sold on the x-axis and total cost on the y-axis:
- Fixed cost line: Flat horizontal line
- Variable cost line: Starts at zero, increases linearly with units
- Total cost: Fixed + Variable; starts at fixed and slopes upward
3. Typical Interview Prompt
“Our client is producing 100,000 units annually. Fixed costs are $2M, variable costs are $8 per unit. If they increase production to 150,000 units, what happens to average cost per unit?”
Answer:
- At 100,000 units: Total cost = $2M + ($8 × 100K) = $10M → $100 per unit
- At 150,000 units: Total cost = $2M + ($8 × 150K) = $14M → $93.33 per unit
Conclusion: Average cost per unit decreases as volume increases.
4. What Are Economies of Scale?
Economies of scale refer to the cost advantages that companies experience when production becomes more efficient. This usually happens as fixed costs are spread over more units.
“As output increases, the cost per unit falls.”
They often result from bulk purchasing, labor specialization, or operational efficiencies.
5. Implications for Strategy
Firms with high fixed costs and low variable costs (e.g., airlines, software) benefit greatly from scale. In contrast, businesses with high variable costs (e.g., consulting) have less leverage from volume increases.
- High fixed cost industries: Push volume to spread costs
- Low fixed cost industries: Focus on efficiency per unit
6. Watch Out For Diseconomies
At some point, growing too large can increase complexity and coordination costs, leading to diseconomies of scale.
“More volume isn't always better—watch for bottlenecks, bureaucracy, and declining marginal returns.”
Final Thoughts
Knowing the difference between fixed and variable costs is essential to understanding cost structures, pricing flexibility, and operating leverage. Combine that with awareness of scale benefits—and limits—to give well-rounded recommendations in case interviews.
Always ask: How does this business scale? What happens when volume changes?