Nearly every business has both fixed and variable costs. To ensure that your business remains fiscally solvent and profitable, it is important to understand the different types of costs and how to manage them.
In general, variable costs relate to the number of items and services your company produces, while fixed costs relate to overhead expenses. Each kind of cost has its advantages and disadvantages. Each may need to be managed differently to protect the bottom line of your enterprise.
In this article, you will learn more about each kind of cost and ways you can control them to your best advantage.
Variable Costs
As the name might suggest, variable costs can go up or down over short periods of time. These costs are often calculated from month to month. Variations are generally due to the production volume of the company. The more products you sell, the greater your cost to produce those products. The more services you sell, the greater your cost to provide and support those services. Conversely, the less you sell, the smaller your costs.
Examples of Variable Costs
Raw material purchases are the most common variable costs. For instance, a furniture manufacturer needs to order more lumber to meet a sudden increase in demand. The variable cost calculation might not always be straightforward. The lumber supplier could provide a discount for larger orders or charge a premium for rush orders.
Another common example of variable cost is hourly labor. In preparation for a holiday sale, the furniture company may need to increase the hours of its part-time employees, pay overtime wages, or bring on temporary help.
Additional examples of variable costs include sales commissions, manufacturing and shipping supplies, and freight costs.
Calculating Variable Costs
Suppose your company makes basketballs. To produce 2,500 balls last month, you spent $4,000 on materials, $3,000 on hourly labor, and $2,500 on packaging materials. Adding up these amounts, your production cost for the month came to $9,500.
In addition to the production expenses, it cost you $500 in electricity to power the manufacturing equipment, $1500 in commissions to the sales staff, and $1500 to ship the basketballs to the distributors. These operational costs add up to $3,500.
Total Variable Cost
Your total cost for producing, selling, and shipping the basketballs, then, was $13,000. We can now calculate the total variable cost of a single basketball by dividing the monthly cost by the number of basketballs produced during the month. 13,000 ÷2,500 = 5.2. So, the total variable cost for each basketball was $5.20.
Now that we know the variable costs, we can create accurate forecasts for coming months. If we have orders for 5,000 basketballs next month, we know our total variable costs will be approximately $26,000.
Uses of Variable Cost Figures
Variable costs are relatively easy to manage. There are several ways to reduce variable costs. For instance, you may look for less-expensive raw materials or cheaper shipping methods. You may be able to increase the efficiency of your manufacturing methods or train employees to work faster.
Once you know your variable costs, you can correctly price your products and services. You can create accurate financial projections. You can use this information in determining breakeven points and determining your business budget.
Learning to determine and control variable costs is an important challenge for every business owner and is essential to sustained profitability.
Fixed Costs
Fixed costs are those that seldom or never change. Typically, a fixed cost involves a specific amount paid on a monthly or annual basis. These amounts stay the same regardless of how much business the company does or how many employees it has. Fixed costs are relatively easy to predict but difficult to adjust.
Examples of Fixed Costs
Common examples of fixed costs are the monthly payments on a business loan or the rent paid on a building. Other fixed costs might include:
- Equipment rental
- Full-time employee payroll
- Internet service
- Property taxes
- Insurance premiums
- Vehicle leases
- Mortgage payments
Calculating Fixed Costs
Fixed costs are obligations that must be paid regardless of whether any products are sold or any profit is made.
For existing businesses, it is typically easy to determine fixed costs. They are the expenses that do not change from month to month. These can be identified by reviewing your company’s income statements and balance sheets to look for costs that stay the same regardless of business activity.
New businesses may need to estimate their fixed costs by doing research and preparing forecasts until a pattern is established.
Where payments are made weekly or annually rather than monthly, most businesses find it preferable to use the average cost per month in determining their fixed cost figures. For example, if you pay $100 per week for equipment rental, you could calculate the monthly fixed cost as follows:
1 year = 365 days = 52.14 weeks
$100 x 52.14 weeks = $5214 per year
$5214 ÷12 months = $434.50 per month
Total Fixed Costs
Total fixed cost is the sum of all the non-variable, consistent expenses a company is obligated to pay. Once you have identified all these expenses you can simply add up the monthly averages to determine your monthly total fixed cost.
For instance, if your business pays $5000 per month to lease a building, $2000 per month for utilities, $3000 per year for insurance, and $100 per week for equipment rental, you could calculate your monthly fixed costs as follows: