Fixed or Variable: Classifying Costs From a Real Ledger
- Start with the right question
- A typical small-business ledger, classified
- Splitting a mixed cost: the high-low method
- Why the classification matters
- Practical rules for a first pass
- Where this fits
A cost is variable if it rises and falls with activity, fixed if it does not change within your normal range of activity, and mixed if it has some of both. Most small-business ledgers are not organised that way. They are organised by type of expense, so before any break-even, pricing or contribution analysis you have to go through the accounts and decide, line by line, how each cost behaves.
It takes an afternoon, and it is the step most analyses skip.
Start with the right question
For each ledger account, ask: if we sold 20% more next month, with no other change, would this cost go up?
- Yes, roughly in proportion: variable.
- No: fixed.
- Yes, but not in proportion, or only part of it: mixed.
“Activity” should be whatever actually drives the cost. For a manufacturer it is usually units produced. For a trader it is sales value. For a service firm it may be billable hours or number of clients. Pick one measure and use it consistently.
A typical small-business ledger, classified
| Ledger account | Behaviour | Why |
|---|---|---|
| Raw materials, goods for resale | Variable | Each unit needs its own |
| Piece-rate or contract labour | Variable | Paid per unit or per job |
| Freight outward, packing | Variable | Per dispatch |
| Sales commission, gateway and marketplace fees | Variable | Percentage of each sale |
| Rent, insurance, software subscriptions | Fixed | Same bill whatever you sell |
| Salaried staff | Fixed, in steps | Constant until you need another person |
| Electricity in a factory | Mixed | Base load plus machine running time |
| Repairs and maintenance | Mixed | Routine plus wear from use |
| Telephone and internet | Usually fixed | Plans are flat |
| Marketing | Fixed by decision | Set by budget, not by sales |
| Interest on term loan | Fixed | Depends on the loan, not activity |
Two entries deserve a comment. Marketing is not variable just because it is meant to drive sales; the spend is decided in advance and stays the same if sales disappoint. Salaried staff are fixed over a range but jump when you hire, which is why the label “stepped fixed” is more honest than either category.
Splitting a mixed cost: the high-low method
A mixed cost has to be separated into its fixed and variable parts. The simplest reliable method uses your own history.
A small plastics moulder has these electricity bills and production volumes over six months. Take the month with the highest activity and the month with the lowest:
| Month | Units produced | Electricity ₹ |
|---|---|---|
| Lowest activity | 4,000 | 1,10,000 |
| Highest activity | 10,000 | 2,00,000 |
| Difference | 6,000 | 90,000 |
Variable cost per unit = change in cost ÷ change in activity = 90,000 ÷ 6,000 = ₹15 per unit.
Fixed part = total cost at either point − variable part. At the low month: 1,10,000 − (4,000 × 15) = ₹50,000 a month.
Check at the high month: 50,000 + (10,000 × 15) = 2,00,000. It reconciles.
The method has one weakness: it uses only two months. If either was unusual, a breakdown, a tariff revision, a week of power cuts, the split is distorted. Before using it, look at all six months and make sure the extremes are typical. If you have a year or more of data, a scatter chart with a trend line in a spreadsheet gives a more reliable split using every month.
Why the classification matters
Suppose the moulder sells each unit for ₹100, with materials and packing at ₹45. If electricity is wrongly treated as entirely fixed, contribution looks like ₹55 a unit. With electricity’s ₹15 correctly included, it is ₹40.
With other fixed costs of ₹4,00,000 a month plus the ₹50,000 fixed electricity:
- Wrong classification, all ₹2,00,000 of electricity at 10,000 units treated as fixed: fixed costs ₹6,00,000, contribution ₹55, break-even about 10,909 units.
- Right classification: fixed costs ₹4,50,000, contribution ₹40, break-even 11,250 units.
The error understates break-even by about 340 units a month. Worse, it depends on the volume you happened to pick. Treat a mixed cost as fixed at one level of activity and every forecast at another level is wrong.
The bigger distortion is in marginal decisions. With electricity left out, variable cost looks like ₹45, so a special order at ₹58 appears to add ₹13 a unit. The true variable cost is ₹60. That order loses ₹2 on every unit it ships.
Practical rules for a first pass
- Classify every account whose annual total is material. Lump the small ones into fixed; the error is tiny.
- Use twelve months of data, not one, so seasonal costs are visible.
- Write the classification down with the reason. Next year, you will want to know why power was treated as mixed.
- Revisit when the business changes shape. A move from salaried delivery staff to a courier turns a fixed cost into a variable one.
Where this fits
- Using the split: break-even analysis · contribution margin and pricing decisions
- Run the numbers: break-even calculator · break-even on ₹2 lakh fixed cost
- Cost variances in manufacturing: standard costing and variance analysis