In the short run, a firm's costs are divided into fixed and variable. Fixed costs are expenses that do not fluctuate with the level of output. These costs remain constant and must be covered even if the firm produces nothing. The owner of the business cannot avoid fixed-cost obligations by simply shutting down and going out of business. That is why businesses sometimes continue to operate when revenues are lower than total costs. As long as the firm can receive enough revenues to cover all variable costs and still make a partial contribution towards their fixed cost obligations, the firm is better off by staying open for business. These costs cannot be avoided if the firm goes out of business.

Fixed costs are commonly associated with items of capital inputs such as depreciation of plant and maintenance of machinery. However, expenses related to labor input can also be a fixed cost. For example, salaries of permanent staff are a fixed cost. The contract is only a fixed cost if the payments in the contract must be paid regardless of whether they are working for the firm or not.

Variable costs are expenses that fluctuate with the level of output. They include expenses such as the wages of daily workers and the costs of materials needed to make the product. If there is no production, no variable costs are incurred. If there is higher production, the variable costs are higher.