The 12-Week MBA Chapter 8: Cost Structures - Fixed vs Variable and Why It Matters

“Sure, we are losing money on every unit we sell. But we will make it up in volume!” That famous line is sometimes a joke about startup founders. And sometimes it is a real business strategy. How do you know which one you are dealing with?

This is post 10 in my 12-Week MBA retelling series.

Chapter 8 is all about cost structures. It explains the difference between fixed and variable costs, why most people misunderstand them, and how the choices you make about costs determine whether growth saves your company or sinks it.

Fixed Costs vs Variable Costs

Let us start with the basics using the book’s food truck example.

You run a grilled cheese food truck. Some of your costs go up when you sell more sandwiches. Bread, cheese, tomatoes, spices. Those are variable costs. Sell more, spend more. Sell nothing, spend nothing on ingredients.

Other costs stay the same no matter how many sandwiches you sell. Truck rental, business permits, your accountant’s salary. Those are fixed costs. You pay them whether you sell a thousand sandwiches or zero.

Simple enough, right? The authors say this is where most people stop. And that is a problem, because there are three big misconceptions people have about this.

Three Things People Get Wrong

1. Accounting Categories Do Not Match Economic Reality

People assume that the cost of making a product (cost of sales) is always variable, and everything else (admin, marketing, research) is always fixed. That is not true.

A plant manager’s salary? That is a fixed cost, even though it shows up under production. Sales commissions? Those are variable costs, even though they show up under selling expenses. The accounting buckets and the economic reality are two different things.

2. Scale and Time Change Everything

Whether something is fixed or variable depends on how close you are looking.

Your four-person team’s salaries look fixed for the next quarter. But for a CEO planning over five years, headcount is absolutely a variable cost that goes up and down with business volume.

Even tiny variable costs can be fixed at small scale. You buy cheese in 20-slice packs. Whether you make 1 sandwich or 20, you bought that pack. And even the biggest fixed costs look variable at massive scale. A TV ad campaign is a fixed cost for one city. But if you are deciding how many cities to run ads in, it becomes variable.

3. Fixed and Variable Relative to What?

We usually think about costs relative to sales volume. But that is not the only way to look at it.

The book gives an example from corporate training. If you are running a leadership workshop, some costs depend on how many people attend: materials, software licenses, travel. Other costs stay the same whether 3 people show up or 30: the instructor’s fee for the day. The “variable” here is not sales but participants.

The takeaway is that fixed versus variable is not some permanent label you stick on a cost. It depends on what you are measuring, at what scale, and over what time period.

The Breakeven Point

Now here is where it gets practical. If each grilled cheese sandwich costs $4 in raw materials (variable cost) and you charge $10, you make $6 of what is called contribution margin on each sandwich. Every sandwich contributes $6 toward covering your fixed costs.

If your fixed costs are $6,000 per month (rent, permits, and so on), how many sandwiches do you need to sell to break even?

Breakeven = Fixed Costs / Contribution Margin = $6,000 / $6 = 1,000 sandwiches

That is about 50 sandwiches a day over 20 working days. Totally doable.

But what if you priced at $4.01 instead? Your contribution margin would be one cent per sandwich. You would need to sell 600,000 sandwiches a month. That is 14 sandwiches per minute, 24 hours a day, all month. Not happening.

This is why the “we will make it up in volume” joke exists. If your margin above variable costs is tiny, the volume you need to break even can be ridiculous.

The math is sixth-grade simple. But the real power of breakeven analysis is in testing assumptions. What if you raise the price to $12? Breakeven drops to 750. But can you actually find customers at that price? What if you cut $1 from variable costs by using cheaper cheese? Breakeven drops to 858. But will customers notice the quality drop?

Every lever you pull has a consequence. Breakeven analysis helps you figure out what questions to ask before you commit.

The Big Trade-Off: Growth, Profit, and Risk

Here is the core insight of this chapter, and it is one of those ideas that changes how you think about business.

If you expect growth, you want more fixed costs. When sales go up, fixed costs stay flat, so profits skyrocket. Your investment in full-time employees, office space, and equipment pays off big time.

If you expect decline, you want more variable costs. When sales drop, variable costs drop with them. You can shrink your expenses alongside your revenue and stay profitable. High fixed costs in a shrinking market turn into devastating losses fast.

If you are not sure what is coming, variable costs are safer. They give you less upside but protect you from catastrophic downside.

The authors share a personal story here that makes this very real. They started their own e-learning company in 2001. Online training was clearly the future. They won awards. Clients came in. Sales grew. They hired full-time employees, expanded the management team, rented bigger office space. They bet on growth with a high-fixed-cost structure.

The problem was their specific niche: custom, high-end multimedia courses. The overall e-learning market did grow massively. But cheaper, simpler courses could be built overseas for much less money. The demand for expensive custom work was unpredictable. Some months the books were full and profits were huge. Other months there was almost nothing coming in, and fixed costs ate them alive.

They eventually had to sell that part of the business. Their competitors who survived in that market relied more on contractors (variable cost) instead of employees (fixed cost). That flexibility kept them alive through the dry spells.

Making Sales More Predictable

Since cost structure risk comes from unpredictable sales, a lot of business strategy is really about making sales more predictable. The book highlights several clever approaches.

Brands lock customers into buying patterns. Your brain tells you that only one brand of toothpaste makes your teeth feel truly clean. That irrational loyalty is incredibly valuable to companies because it means they can predict how much they will sell next quarter.

Subscriptions reduce the number of times a customer has to decide. Microsoft moved from selling Office as a one-time purchase to Office 365 as a monthly subscription. Now customers have to actively choose to leave instead of actively choosing to buy. That creates a steady, predictable cash flow. Amazon Prime works the same way.

The razor blade model means selling the main product cheap and making money on the refills. Sony sells PlayStation consoles at tiny margins because gamers then buy high-margin games for years. GE Aviation sells jet engines cheaply because the service and parts contracts last decades. Even the name comes from this: cheap razors, expensive replacement blades.

Factoring is a financial service where a company sells its accounts receivable (money customers owe) to a third party at a discount. You get cash now instead of waiting 90 days. Someone else worries about collecting.

All of these strategies are about the same thing: making the future more predictable so you can make smarter bets on your cost structure.

So Can Uber Make It Up in Volume?

The book circles back to its opening question about Uber. By 2021, Uber had accumulated losses over $26 billion on $17 billion in yearly sales. Their CEO told employees in 2022 that they need to make sure the math works per ride before going bigger. In 2022 they did $32 billion in revenue and still lost money.

Uber is betting on the high-fixed-cost growth scenario. They believe that eventually their slim margins above driver costs (variable) will cover all the fixed costs of running the platform. As of the book’s writing, Uber finally managed a small profit in mid-2023.

Whether that profit holds and grows is the multi-billion-dollar question. The cost structure framework from this chapter gives you the tools to think about it for yourself.

Key Takeaway

Your cost structure is not just an accounting detail. It is a strategic choice that ties together everything we have talked about so far: profitability, growth, and risk.

High fixed costs are a bet on growth. If you are right, profits multiply. If you are wrong, losses multiply just as fast. Variable costs are the conservative play. Less upside, but you can survive the bad times.

The smartest thing you can do is be honest about how predictable your sales really are. Then structure your costs to match that reality, not your hopes.

Book: The 12-Week MBA by Nathan Kracklauer & Bjorn Billhardt | ISBN: 978-0-306-83236-9

Previous: Chapter 7 - Cash Flow and Working Capital Part 2

Next up: Chapter 9 - Valuation Foundations - How to figure out what a company is actually worth.

Part of the 12-Week MBA retelling series