Fixed and variable costs, operating leverage, and unit economics
How costs behave when sales change, and what one order or one customer is worth.
Key takeaways
- Fixed costs stay the same when sales change; variable costs move with each unit sold.
- Common mistakes: Calling a cost fixed when it only stays flat over a small range.
- Unit economics means looking at the money from one unit: one order, one customer, one store.
Key idea
Fixed costs stay the same when sales change; variable costs move with each unit sold. A business with high fixed costs sees its profit rise and fall much faster than its sales.
| Business | Fixed costs (stay the same) | Variable costs (move with sales) |
|---|---|---|
| Airline | Aircraft leases, head office | Fuel per flight, airport fees, meals |
| Software company | Engineers, offices | Cloud hosting per user, payment fees |
| Restaurant | Rent, most staff salaries | Ingredients, packaging, delivery commission |
| Factory | Machines, building, supervisors | Raw materials, energy per unit |
So-what
Some costs are fixed only up to a point. A restaurant that doubles its sales will need more staff. Say this when it matters.
Worked case
Operating leverage: the same sales growth, very different profit growth
The prompt
Two companies in Singapore each have revenue of SGD 1 million (1,000 thousand) and profit of SGD 100 thousand. All figures below are in SGD thousands. Company A has variable costs of 200 and fixed costs of 700. Company B has variable costs of 700 and fixed costs of 200. Sales rise 10 percent at both. What happens to profit?
The structure
- New profit = new revenue minus new variable costs minus the same fixed costs
- Revenue and variable costs both rise 10 percent
- Fixed costs do not change
Working it through
1. Company A today
Revenue 1,000 minus variable 200 minus fixed 700.
Profit A today (SGD thousands):1,000 - 200 - 700 = 1002. Company A after growth
Revenue 1,100, variable costs 220, fixed costs still 700.
Profit A after (SGD thousands):1,100 - 220 - 700 = 1803. Company A profit growth
Profit went from 100 to 180.
Profit growth A (percent):(180 - 100) ÷ 100 × 100 = 804. Company B after growth
Revenue 1,100, variable costs 770, fixed costs still 200.
Profit B after (SGD thousands):1,100 - 770 - 200 = 1305. Company B profit growth
Profit went from 100 to 130.
Profit growth B (percent):(130 - 100) ÷ 100 × 100 = 30
The recommendation
The answer is that Company A's profit grows much faster: the same 10 percent sales growth lifts it 80 percent, to SGD 180 thousand, against 30 percent, to 130 thousand, at Company B. The reason is operating leverage: Company A has fixed costs of 700 and variable costs of only 200, so most extra sales fall straight to profit. This means the risk runs in reverse too: if sales fall, Company A's profit falls much faster. As a next step, check how stable each company's sales are before judging which cost structure is better.
Unit economics: what one order or one customer is worth
Unit economics means looking at the money from one unit: one order, one customer, one store. The key numbers are the contribution per unit (price minus the variable costs of that unit), the customer acquisition cost (CAC: what it costs to win one new customer), and the customer lifetime value (LTV: the contribution one customer brings over the whole time they stay). A healthy business usually has an LTV several times larger than its CAC.
Worked case
Unit economics of a food delivery app in India
The prompt
A food delivery app in India takes a 25 percent commission on an average order of INR 400. For each order it pays INR 45 to the rider, INR 8 in payment fees, and INR 7 for customer support. A new customer costs INR 300 in marketing to win, orders 3 times a month, and stays 8 months on average. Is a customer worth winning?
The structure
- LTV compared with CAC
- Contribution per order = commission minus variable costs per order
- LTV = contribution per order x orders per month x months retained
- Compare LTV with CAC of INR 300
Working it through
1. Revenue per order
The app keeps 25 percent of the order value.
Commission per order (INR):400 × 0.25 = 1002. Contribution per order
Subtract rider, payment, and support costs.
Contribution per order (INR):100 - 45 - 8 - 7 = 403. Lifetime value
40 per order, 3 orders a month, for 8 months.
LTV (INR):40 × 3 × 8 = 9604. LTV compared with CAC
Divide LTV by the cost to win the customer.
LTV to CAC ratio:960 ÷ 300 = 3.2
The recommendation
Yes, the app should keep winning customers, since each one brings about INR 960 of contribution for INR 300 of marketing, an LTV to CAC ratio of about 3.2. This is because each order contributes INR 40, and a customer orders 3 times a month for 8 months. The biggest levers are keeping customers longer and lowering the INR 45 rider cost per order. The main risk is churn: if customers leave after 3 months instead of 8, LTV falls to INR 360, close to the cost of winning them. Next, track retention by monthly cohort before raising the marketing budget.
Risks: This ignores fixed costs such as the tech team; If customers leave after 3 months instead of 8, LTV falls to INR 360.
A software customer pays USD 50 a month. The gross margin is 80 percent, and customers stay 20 months on average. What is the customer lifetime value in USD? (Use gross margin as the contribution per customer here.)
Calling a cost fixed when it only stays flat over a small range. Using revenue instead of contribution when calculating LTV. Forgetting that churn (customers leaving) shortens lifetime and lowers LTV. Assuming high operating leverage is always good: it also makes losses grow fast when sales drop.
Which is a variable cost for an airline?
A company has very high fixed costs. Sales fall 10 percent. What most likely happens to profit?
LTV is INR 900 and CAC is INR 1,200. What does this suggest?
Sources for this lesson (1)
- Recognized public explanations of case-interview concepts and terms
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