Successful operation of a small business hinges on managing two types of expenses: fixed and variable. As the names imply, fixed expenses are stable amounts that must be paid routinely. Variable expenses, on the other hand, constantly change depending on your sales. Here’s what you need to know about both:
You have to pay fixed costs regardless of your revenue. For instance, telephone and internet are essential business costs. Bills for these expenses are paid even if you have no revenue for the month. Rent and payroll are other common fixed expenses for a small business. Every entrepreneur should also plan for some amount of recurring personal compensation. You don’t want to run your business without reward for your effort!
Controlling variable expenses is key to constructing a workable design for business success. Why? The management of these costs is necessary to fund your recurring fixed expenses.
Typically, variable costs should rise when revenue increases and decline when revenue decreases. The obvious category to examine for these trends is the costs of goods sold on your income statement. Examples of these variable inputs are materials, parts, and components necessary to complete business sales.
These variables directly impact your gross profit margin (revenue minus cost, divided by revenue). The goal should be to maintain a constant gross profit margin by properly managing your expenses. To do this, you must ensure that variable expenses rise and fall in step with revenue, so your costs don’t throw off the equation.
Of course, maintaining steady expenses can be challenging when costs are variable by nature. And in some cases, the expenses are semi-variable.
Labor is the main expense that falls into this category. While direct labor related to customer interaction is typically variable, general office personnel may be needed regardless of sales volume, and administrative wages are almost always a fixed cost.
General overhead expenses can also shift from fixed to variable. For example, you might choose to spend more on marketing and advertising if sales take a downturn. You may also divert some of your direct labor from other projects to beef up marketing efforts.
Market prices may also change, taking control of costs out of your hands and limiting your spending decisions. Entrepreneurs must adjust to changes in cost of materials and labor as they occur. The obvious course of action is to increase or decrease sales prices in response to new costs.
Eye on the Margin
Accounting for all these fluctuations is crucial to identifying optimal use of your resources. Remember, revenue minus variable costs is what’s left to pay for fixed expenses. You must know which expense categories are genuinely changing with shifts in revenue in order to effectively monitor costs and make necessary adjustments.
This will allow you to calculate a modified gross profit margin that provides a realistic look at your finances. You can multiply this gross profit margin by your expected revenue to calculate how much you will have to pay fixed expenses and how much will be left over to grow your business.
A financial professional can help you navigate these numbers and suggest steps to further the success of your company.