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Understanding Fixed vs. Variable Costs in Your Business
Posted by Sylvia Lagerquist, CPA
Managing costs is one of the single most critical priorities facing any business owner. Even if your business is currently generating substantial new revenue, if you don’t know how to manage costs, you could end up in even worse shape than when you started.
That’s why it’s essential to understand how costs work in your company: what costs will go up, which will go down, when, and why.
The Role of Fixed vs. Variable Costs in Managing Your Small Business
One fundamental priority for every business owner is to understand the difference between fixed and variable costs in the business. Business expenses (i.e. costs) are generally categorized either as fixed or variable.
Understanding Fixed Costs
Fixed costs are those that do not change even when the company’s sales volumes or production levels increase. These generally include costs expenses such as:
• Dues and subscriptions
• Equipment leases
• Management salaries
• Marketing and advertising
• Interest on loan payments
Understanding Variable Costs
Variable costs, on the other hand, are those that are directly impacted by changes in activity levels or the volume of products or services your company generates. Put another way, these are costs that can go up and down on a regular basis – or that don’t exist if your business has no revenues. Variable costs generally include:
• Direct labor for service companies
• Sales commissions
• Cost of goods purchased for resale
• Packaging supplies
• Shipping costs
Why Fixed Costs Are Important
The reason it’s so important to understand fixed costs in your business is that they stay the same, even if your new revenues grind to a halt. Did you suddenly lose your largest customer account, worth 20% of your annual sales?
Sorry, but you still have to cover the rent; insurance; phone and internet services; staff salaries; and so forth. It’s essential to know what these costs are, and to budget strategically so that they are manageable – no matter what the future holds. Covering fixed costs is a necessary fundamental in order to keep your business alive.
Why Variable Costs Are Important
The important point about variable costs is that they do not rise and fall based upon the company’s activities. In fact, they can rapidly increase, decrease or eliminate your profit margin and lead your company into a sudden profit or a steep loss. In addition, variable costs are important to consider when establishing prices. In short, knowing and managing variable costs is essential as you respond to changes in the marketplace and in your company’s growth patterns.
How to Use Costs to Your Company’s Advantage
A solid understanding of your company’s fixed and variable costs is what allows us to identify the profitable price level for its products or services. You can use this knowledge to identify your break-even point, which is the number of units or dollars at which total revenues equal total costs.
You can also use this information to identify economies of scale, which is rooted in the fact that as output increases, fixed costs are spread over a larger number of output items (products or services).
Break-even analysis is an important assessment method that all business owners should perform.
Next Steps to Success
There is a lot more we could discuss when it comes to fixed and variable costs. To dig in deeper, we encourage you to review the resources shared below, and stay tuned for future articles on our blog with examples and other details relating to costs.
And of course, feel free to contact Haines & Lagerquist CPAs to discuss how better costing strategy can enhance the performance of your business.
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