Small-business owners must understand the differences between fixed and variable expenses and how they affect a company’s success.
All business expenses can be categorized as either fixed expenses or variable expenses.
Fixed expenses must be paid no matter how many goods or services you offer for sale.
But just because you cannot immediately change your fixed costs doesn’t mean you should ignore them.
If you can sell more products and generate more income, your fixed costs will be a smaller percentage of your overall expenses.
Fixed expenses are costs that do not change when production levels or sales volumes rise or fall.
Fixed expenses include costs such as rent, insurance, equipment lease or rental expenses, and loan repayments.
Some fixed costs, such as advertising and promotional expenses, are considered discretionary, while other fixed costs are nondiscretionary and exist even if production or sales volumes drop to zero.
Variable expenses are costs that vary directly with changes in production activity levels or sales volume. Variable expenses include things like raw materials, sales commissions, inventory, packaging and shipping costs.
Production and sales volume are the two primary factors that determine variable expenses. However, other factors, such as changes in input costs and transportation costs, also impact the level of variable expenses.
Some expenses, such as utilities and personnel, have both fixed and variable components. For example, an employee may receive a fixed base salary and also earn a variable commission based on sales volume, production quotas or quality thresholds.
Total fixed costs do not fluctuate as unit volume increases, but fixed costs per individual unit decline in this situation.
The more widgets you produce, the less each one claims as a percentage of your total fixed overhead, since the cost is spread over more units. This is not the case with variable costs. Total variable costs increase as volume increases, while variable costs per unit do not change.
As a small-business owner, a working knowledge of fixed and variable expenses allows you to determine your company’s break-even point – the number at which total revenues equal total costs. The break-even point is a key piece of information to consider when making many important strategic decisions.
This formula is the first step in performing a break-even analysis. The number of units required to break even = fixed costs / price variable costs per unit.
This equation gives a small-business owner valuable information about how costs respond to changes in the volume of goods or services produced.
It can also be used to answer other key questions, such as whether a planned expansion will be profitable, whether margins are adequate or whether price increases are necessary.
Knowing how to use this information about fixed and variable expenses is critical if you are considering expanding or developing a new product line and for determining optimal pricing strategies.