All organizations have to pay certain expenses just to stay in business, regardless of how many sales they make. Examples of so-called fixed expenses include rent, electricity and property taxes. Other costs are variable, which means they go up or down with the volume of sales or production. Labor can be either a fixed or variable cost, depending on how you pay your workers.
Salaried Labor is a Fixed Cost
A fixed cost is one that stays the same every month regardless of how much you're selling. Examples include your rent, utilities, accounting expenses and annual staff salaries. Salaries are classified as fixed costs when they do not vary with the number of hours a person works, or with the output rolling off your production line. So, a full-time salaried manager earning $40,000 per year is still required to manage and is contractually entitled to receive his $40,000 salary, regardless of how many widgets you're manufacturing. The amount is fixed.
Commissions are Variable Costs
A variable cost is one that goes up or down depending on production levels. Packaging and shipping are good examples of variable costs – these expenses clearly go up when you're selling more goods and down when the orders stop coming in. In terms of your payroll, if you pay a worker according to output, then the wage bill will be a variable cost. Take the example of a sales associate who is paid a 10-percent commission based on the amount of product she sells. If she makes $100,000 worth of sales, her salary will be $10,000. If she makes no sales, her commission will be $0. The amount varies depending on sales volume. It is a variable cost.
Hourly Wages Can Be Fixed or Variable Costs
Hourly rate labor may be fixed or variable depending on the circumstances. If the worker is paid an hourly wage but is contractually guaranteed a fixed number of hours each week, and is paid for the fixed number of hours irrespective of his actual working hours, then the worker is effectively a pseudo-salaried worker. The labor cost is considered a fixed cost. When you pay only for the number of hours worked on an as-needed basis – which is usually the case when hiring temporary or contract laborers or piece-workers – then it is considered a variable cost. It goes up or down with production.
Mixed or Semi-Variable Expenses
Labor must be either a fixed cost or a variable cost – it cannot be both. There can, however, be fixed and variable components of a wage bill. Suppose, for example, you pay your sales associate a base salary (fixed cost) with a top-up commission based on the volume of sales achieved (variable cost). Now, you have a semi-variable or mixed expense with both fixed and variable elements. Any worker who earns a base salary plus overtime falls into this category. That's because your overtime bill increases in line with the volume of work your employee is producing.
How to Decide Whether a Labor Cost is Fixed or Variable
A good rule of thumb for determining whether a labor cost is variable or fixed is to ask whether you would incur the cost if the business closed operations for the day. Labor costs that would need to be paid such as management salaries are fixed costs. Labor costs that would not need to be paid such as commissions, piece workers, hourly rates and overtime wages are variable costs. Maximizing variable labor costs and minimizing fixed labor costs is one way to reduce overhead, and stay profitable during slow-selling periods.