The reading level for this article is Novice
This question keeps on popping up and complicating business decisions. Not being able to answer this very important question leads to bad business decisions being made and is a major cause of small businesses going bust. To have a strong and successful business, you need a clear understanding of the financial impact that your most basic business decisions may have.
For example, do you know what your most profitable products or services are, so that you (or your salespeople) can really push those? Do you know what will happen if your sales volume drops? How far can it drop before you really start to eat red ink? If you lower your prices in order to sell more, how much more will you have to sell? If you take out a loan and your fixed costs rise because of the interest on the loan, what sales volume will you need to cover those increased costs?
To be able to answer these questions, you need to have a good understanding of what your fixed costs, variable costs and profit margins are. You also need a good understanding of the relationships between these variables. Cost/volume/profit analysis helps you answer these, and many more, questions about your business operations.
This is the first in a series of 4 articles on how these tools can be applied to your business. This article looks at the distinction between fixed costs and variable costs and what this means to you. In the next three articles, we will look at breakeven analysis, contribution analysis and operating leverage.
Types of costs: Virtually all of your business’s costs fall, more or less neatly, into one of two categories:
· “Variable costs” which increase directly in proportion to the level of sales. Some examples would be cost of goods sold, sales commissions, shipping charges, delivery charges, costs of direct materials or supplies, wages of part-time or temporary employees, and sales or production bonuses. Variable costs increase as sales go up and decrease as sales come down and can be directly built into selling prices.
· “Fixed costs” which remain the same regardless of your level of sales. Typical examples would be rent, interest on debt, insurance, plant and equipment expenses, business licenses, and salary of permanent full-time workers. Because they are not directly linked to sales, fixed costs have to be recovered by spreading them across all sales transactions, using a systematic method.
A business advisor can help you determine which of your costs are fixed and which are variable, but here the key word is “help.” In order to be accurate, the ultimate classification has to be done by someone who’s intimately familiar with your business operations — which probably means you.
Combination costs: Some costs are a combination of fixed and variable: a certain minimum level will be incurred regardless of your sales levels, but the costs rise as your volume increases. Your phone bill is an example. You pay a line charge that is the same each month, and you also pay a charge based on the number of calls you make. Strictly speaking, these costs should be separated into their fixed and variable components, but that may be more trouble than it’s worth for a small business. To simplify things, just decide which type (fixed or variable) best describes the cost and classify the whole item accordingly. For example, in a telemarketing business, phone call charges are normally far greater than line charges, so you’d classify the entire bill as variable.
Relevant range of activity: It’s important to realize that fixed costs are “fixed” only within a certain range of activity or over a certain period of time. For example, your rent is a constant amount per month until your sales increase to the point where you need to rent an additional workplace, in which case it might double. In the long term, all costs become variable. But for the purpose of understanding your cost structure, costs that stay constant over a 12-month period are regarded as fixed.
Pricing decisions: Over a 12-month period, your Gross Profit is equal to Sales minus Variable Costs. To make ends meet, your Gross Profit must be at least as much as your Fixed Costs. If they aren’t, you will make a loss. And if this keeps on happening, you will go out of business. So, when pricing a contract, you must ensure that you are making adequate provision for covering your fixed costs. To do this, you need to work out your fixed cost recovery rate and include this in your pricing.
In the next article, we build on your understanding of your costs structures, work out sample fixed cost recovery rates and show how to include it in your pricing. This will enable you to make sound business decisions, based on well understood cost/volume/profit implications.