Fixed Cost vs. Variable Cost

As a business owner there are two key groupings for costs that it is important to understand, fixed costs and variable costs. By understanding these two concepts and the types of costs that fall into these groups can greatly assist with managing your business.

Fixed Costs

Fixed costs are the types of costs incurred in your business where the costs are going to be incurred no matter what level of production or sales you are generating. Costs like rent, insurance, lease or loan payments, and management salaries would all be examples of fixed costs.

Identifying all of a businesses fixed costs and what percentage of your cost structure they make up is important.
If fixed costs together are too high a business can struggle during a slow sales period as a relatively high number of expenses will still need to be paid out of the company. Many companies now seek to reduce their overall fixed costs through careful review and identifying ‘pay for use' arrangements to avoid what would conventionally be fixed expenses.

Variable Costs

Variable costs are the types of costs incurred in your business where the costs will vary based on the volume of sales or production. For a manufacturing company, variable costs would include raw materials, utilities (i.e. power and water), some salaries, and any other costs that will change depending on your actual sales volumes.

Identifying all of a business's variable costs is very important for several reasons. First, clearly understanding what costs will move in line with sales will help identify any costs that are giving irregular results from month to month. Second, knowing all of your variable costs lets you determine the profit margin on your sales and determine things like what the business's break even sales volume will be or what each additional sale actually generates in terms of profit. This can also be very useful in bidding for a contract as you know exactly what your bottom line is where a proposal will or will not remain profitable.

It's also important to know what your variable costs are per sale so that you know you are making a profit every time you make a sale. If your variable costs exceed your revenues you're never going to generate a profit or be able to cover what fixed costs you may have.

Fixed Cost vs. Variable Cost

Fixed costs and variable costs both contribute to providing a clear picture of your overall cost structure. Understanding the components clearly in terms of which costs are set and which costs are incremental provides a great deal of insight into your business and can impact seemingly unrelated concepts like sales proposals.

Increasingly companies are seeking to reduce fixed costs and move to having a cost structure that includes relatively more variable costs. This ensures that if costs are incurred, you know that revenue has been generated in association with those costs. Significant fixed costs can be difficult to manage, particularly if a business is seasonal and can only rely on revenues being generated during specific time periods.
By Jeffrey Glen

Copyrighted 2016. Content published with author's permission.

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