Why an Understanding of Fixed Vs Variable Costs Is Important for Small Business Profitability

One of the burdens of being a business owner is that you have to develop an understanding of accounting terminology. This might seem sleep inducing and potentially unnecessary, particularly if you have an accountant, however being able to distinguish between fixed and variable costs is actually key to better financial insights into your business and can influence how you determine pricing, help you understand how much you need to sell to start turning a profit and contribute to better cash flow reporting. Additionally it can actually be quite interesting and easy to grasp once you are able to see how it applies to your business.

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What is a fixed cost

Very simply a fixed cost of the business is one that you have to incur regardless of business performance and generally remains the same (fixed) over the period being measured. These largely comprise overhead expenses although these two concepts (fixed cost and overhead) are not interchangeable. For example rent of your office premises is a fixed cost since you have to pay rent regardless of whether you generate any sales and the amount is the same every month . It is also an overhead because it does not directly relate to the cost of making your product. Conversely wages paid to factory workers are a fixed cost since they have to be paid at a fixed amount every period but they are not an overhead cost since they directly relate to production.

What is a variable cost

Variable costs are costs that directly relate to the product itself and generally increase or decrease in direct proportion to the volume being produced. The most common example are the raw materials that are required to make the product. For example cucumbers are a variable direct cost of making pickles.

As always there are some grey areas eg: perishable raw materials, although variable do not always have a one to one correlation. Several cucumbers in a batch may have gone bad which leads to spoilage. This can be tracked separately on the financial statements and will still be a variable cost as it will increase or decrease with the volume of sales, although not necessarily in direct proportion. That being said, with a good financial reporting system, a trend will start to develop that will allow you to predict the percentage of raw materials that may be unusable. .

Examples of variable costs (using pickles as an example):

• Raw materials - pickles, vinegar, dill, spices etc.

• Packaging - there is a fixed number of pickles in each jar

• Labels are required for each jar

• Shipping costs are usually based on volume of jars

• Overtime for employees when additional orders are required

• Commissions which are based on a number of sales or volume of jars sold

• Taxes are usually calculated based on a percentage of income

Examples of fixed costs:

• Rent (as discussed above)

• Salaries to employees (excluding overtime, which is variable)

• Utilities to the extent that there is a fixed monthly charge. Additional production increases are similar to overtime for employees

• Telephone and computer expenses

• Office supplies, furniture and fixtures

• Tools and supplies can be a hybrid of variable and fixed costs as these are more sensitive to changes in production volume

• Insurance

• Interest expense on loans and bank fees

• Security (alarm, cameras etc.)

• Factory equipment is fixed up to a certain capacity although the depreciation method selected might change it to a variable cost if it is based on units of production. Note that this is another example of a cost that is fixed but not overhead

It should be stated that all costs are variable over time. As sales increase, you will require a larger premises, more employees, utilities and insurance will be higher etc.

Understanding the distinction and having a good classification system to differentiate between variable and fixed costs is essential for many types of financial analysis. This includes breakeven analysis , which communicates how much you need to sell to cover your costs. A seasonal business may have the bulk of their sales in the summer months but have to ensure that they have the cash flow to cover their costs all year for which an understanding of fixed costs that have to be paid irrespective of sales. Marginal revenue analysis which determines how much additional revenue is generated by each sale (until you require more capacity) requires fixed vs variable input. Ultimately, a fundamental understanding of these concepts can result in higher profits and longevity of your business.

Ronika Khanna is an accounting and finance professional who helps small businesses achieve their financial goals. She is the author of several books for small businesses and also provides financial consulting services.

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