Fixed, variable, opportunity and sunk costs
Learning goals
After this page, you can:
- Classify a cost line as fixed or variable with one test — “does this bill change if we make one more unit this month?” — including mixed costs that are part fixed, part variable.
- Explain opportunity cost and implicit cost (the owner’s own building or time), and include them in a decision.
- Identify a sunk cost, keep it out of a forward-looking decision, tell “fixed” apart from “sunk” — and apply all of this to the cost lines of a 10-K income statement.
The idea
A bakery-café owner looks at last month’s bills. Flour, butter and boxes went up, because she sold more. Rent, insurance and the manager’s salary did not move at all. And the $8,000 market-research study from last spring still nags at her when she thinks about changing the menu — even though that money is gone whatever she does next.
Those three feelings match three kinds of cost. Getting them straight is most of what a manager needs to price well.
Fixed and variable: one test. Ask one question about each bill: does this bill change if we make one more unit this month?
- No → it is a fixed cost (F). Rent, insurance, the manager’s salary, the loan payment on the oven. They are the same whether the café sells 2,000 loaves or 3,000.
- Yes → it is a variable cost (VC). Flour, butter, boxes, card fees, hourly staff scheduled to match traffic. They rise with every unit sold.
Total cost is simply the two added together: TC = F + VC.
Many real bills are mixed costs: part fixed, part variable. Electricity is a good example. The lights and the walk-in fridge run all month no matter what. The ovens use more power the more you bake. Split the bill: a fixed base plus an amount per unit. Then apply the test to each part.
Opportunity cost: a real cost with no bill. The opportunity cost of using something is the value of its best other use. Suppose the owner owns her building, so she pays no rent. A neighbor offers $3,000 a month to rent it. If she keeps the café open, she gives up that $3,000 every month. So the building costs her $3,000 a month, even though no bill arrives.
Costs paid in cash are explicit costs. Costs with no bill — the owner’s building, the owner’s own time, money that could earn interest elsewhere — are implicit costs. Economists add both together:
Economic cost = explicit (cash) cost + implicit (opportunity) cost.
This is why a business can show an accounting profit and still be a poor use of the owner’s building and time. If the owner could earn $60,000 a year working elsewhere, that salary she gives up is a cost of running the café.
Sunk cost: cross it out. A sunk cost is money already spent that you cannot get back, whatever you do next. The $8,000 research study is sunk. A non-refundable deposit is sunk. Custom equipment with no resale value is sunk.
The rule is simple and hard to follow: a sunk cost gets zero weight in any decision about the future. Ask only: from today on, which choice brings in more than it costs? The $8,000 is gone under every choice, so it cannot make one choice better than another.
People find this hard. We feel we must “get our money back” or “not waste” what we spent. That feeling has a name: the sunk-cost trap. It keeps failing projects alive and keeps prices too high, because managers try to spread money that is already gone over future customers.
Fixed is not the same as sunk. These two get mixed up all the time.
- A fixed cost does not change with output this period. But it can often still be avoided: you can choose not to renew a lease, close a store, or sell the oven.
- A sunk cost cannot be avoided by anything you do now. It is history.
Next year’s rent on a lease you can end is fixed but not sunk. Last spring’s research study is sunk. When you decide whether to close a store, the rent you could escape matters. The money already spent to fit out the store does not.
Reading a 10-K income statement with these labels. A company’s annual report (the 10-K) shows its costs as lines on the income statement (Item 8). The lines are not labelled fixed or variable, so you must classify them. Good default assumptions:
- Cost of revenue (or cost of goods sold) → mostly variable. More sales need more ingredients, materials and packaging.
- Occupancy (rent), SG&A, R&D, depreciation and amortization → mostly fixed. They follow the size of the company, not this month’s sales.
- Impairments and restructuring charges → leave out. They are sunk or one-time and say nothing about next year’s cost of one more unit.
These are defaults, not laws. A company that schedules its staff to match traffic has labor that behaves like a variable cost. Always state your assumption in one short line.
Why managers care: the contribution margin. Once you split the costs, two numbers fall out. The contribution margin is revenue minus variable cost: what is left to cover fixed costs. The contribution-margin ratio (CM ratio) is that margin as a share of revenue. The CM ratio tells you how much of each extra sales dollar is kept. The fixed costs tell you how much has to be covered before there is any profit. The next page turns these into a break-even point.
TC = F + VC · Economic cost = explicit (cash) cost + implicit (opportunity) cost
Contribution margin = Revenue − Variable cost · CM ratio = (Revenue − Variable) ÷ Revenue · Break-even revenue = Fixed ÷ CM ratio
Sunk cost → weight zero in any decision about the future. Fixed ≠ sunk: a fixed cost may still be avoidable.
Try it
The builder opens with a fictional bakery-café company. Every total updates as you type or switch a toggle. Your entries are saved in this browser only, and the same builder appears on the short-run cost curves page.
- Switch “Hourly café labor” from Variable to Fixed. What happens to the CM ratio and the break-even revenue? Why?
- Switch “Impairment of closed cafés” from Leave out to Fixed. How much does break-even move? Does the impairment really change next year’s costs?
- Press Use my numbers (or type your company’s 10-K numbers). Add the other cost lines and set each toggle. Write one short reason per line.
- Press Save to My Numbers, then Copy classification table and Export PNG for your Playbook page.
Worked example
Problem. A fictional bakery-café company reports these lines in its income statement ($ millions): revenue 500; ingredients and packaging 175; hourly café labor 125 (scheduled to traffic); occupancy (rent) 60; general and administrative 55; depreciation and amortization 30; impairment of closed cafés 15. Classify each line, then find the contribution margin, the CM ratio, the break-even revenue and how far sales could fall before fixed costs are uncovered.
Step 1. Classify. Variable: ingredients and packaging (175) and hourly labor (125). Fixed: rent (60), G&A (55), D&A (30). Leave out: the impairment (15) — it is sunk.
Step 2. Totals. Variable = 175 + 125 = 300. Fixed = 60 + 55 + 30 = 145. Left out = 15 (shown, never added).
Step 3. Contribution margin and CM ratio. 500 − 300 = 200. 200 ÷ 500 = 40%. Each extra $1 of sales leaves 40 cents to cover fixed costs.
Step 4. Break-even. Break-even revenue = 145 ÷ 0.40 = 362.5. Sales could fall (500 − 362.5) ÷ 500 = 27.5% before fixed costs are uncovered.
Step 5. Operating income. 500 − 300 − 145 = 55 before the impairment, 40 after it. The 15 changes no pricing decision for next year: the closed cafés are gone either way.
Step 6. The cost you cannot see. The company owns some of its café buildings outright, so no rent line appears for them. But it could lease them out. The rent it gives up is a real (implicit) cost of using those buildings, and belongs in any decision to keep those cafés open.
Check yourself
A bakery’s electricity costs $400 a month for lights and the walk-in fridge, plus about $0.05 per loaf for oven energy. How should the bakery classify its electricity cost?
Test each part of a bill: does it change if we make one more unit this month?
A bakery is setting next month’s prices. Which of these is a sunk cost for that decision?
Sunk = already spent and cannot be recovered; it gets zero weight in a decision about the future.
A bakery owns its building, so it pays no rent. A neighbor offers $3,000 a month to rent the building. For deciding whether to keep the bakery open, what is the monthly cost of using the building?
Opportunity cost = the value of the best alternative use, bill or no bill.
Which statement about fixed and sunk costs is correct?
Fixed = does not move with output; sunk = already spent and unrecoverable.
In a bakery-café company’s 10-K income statement, which line is most likely to be mostly variable in the short run?
Default split: cost of revenue mostly variable; occupancy, G&A and D&A mostly fixed. State your assumption.
Video
Video coming soon.