We investigate the joint asset pricing effects of variable costs and fixed costs in a firm's production process. While the latter such as SG&A expenses create an operating leverage effect, the variable costs allow firms to hedge against aggregate profitability shocks. Taking into account both types of production costs explains the empirical patterns in the cross-section asset returns in portfolios sorted by the gross profitability and operating leverage. Our model reconciles the seemingly contradictory phenomena that higher productivity firms earn lower returns (Imrohorouglu and Tuzel, 2014), whereas more profitable, often more productive, firms earn higher returns (Novy-Marx, 2013). It also offers a novel explanation for the negative idiosyncratic volatility premium (Ang, Hodrick, Xing, and Zhang, 2006) based on production costs.