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.
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 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:
Use of Total Fixed Cost Figures
Knowing your fixed costs helps you to create accurate budgets and forecasts. They help you understand how much you need just to keep the business running. Although fixed costs are harder to adjust than variable costs, there are things you can do to lower them, including:
- Negotiate lower rent or move to a less-expensive facility
- Relocate to a jurisdiction that has lower business taxes
- Change to a less costly utility plan
- Purchase equipment rather than renting it
- Lay off some employees
You can calculate fixed costs per product by dividing the total fixed cost by the number of products produced. This figure can be useful in determining breakeven points and product pricing. You can get more information about doing a breakeven analysis at this link.
Combining Variable and Fixed Costs
Adding together the fixed and variable costs per product gives you the total cost of the product. For instance, if the variable cost per basketball is $5.20 and the fixed cost is 80 cents, your total cost is $6.00 per ball. This means you must charge your customers more than that to make a profit.
Let’s assume you decide to sell your basketballs for $11 each. That’s a nominal profit of $5 per ball. Suppose you have annual fixed costs of $30,000. That means you have to sell 6,000 basketballs per year just to break even ($30,000 divided by $5). This covers your fixed costs for the year.
If you sell more basketballs, your cost for each additional ball goes down to $4.40, since you only have to include the variable costs. So, for every 1,000 balls you sell beyond the breakeven level of 6,000, your cost is $4,400 and your profit is $6,600. If your profit target for the year is $50,000, you will either need to sell 13,576 basketballs at $11.00 each (7,576 plus the 6,000 breakeven point) or increase your profit per ball by reducing costs or raising your selling price.
Understanding and carefully managing your variable, fixed, and total costs is critical to running a profitable business. These figures will help you evaluate your current situation and create accurate budgets and financial forecasts going forward. If you need help in determining or managing costs, give Preferred CFO a call. We will be glad to assist.
About the Author
A veteran of the financial services industry, Kyle has served as CFO, COO, and Senior Auditor for organizations such as Arthur Andersen, LLP and CSI Capital Management, Inc. He has also served as the CFO for the general partners of Athlon Venture Fund I, LP and Dawson Real Estate Fund, LP.
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