A Guide to Fixed and Variable Costs of Doing Business
Learn the Difference Between Fixed and Variable Costs
When you start a small business, you will have two types of expenses: fixed costs and variable costs. Fixed costs do not change with sales volume, but variable costs do. Learn more about these types of costs and what they mean for your business.
What Are Fixed Costs?
Fixed costs are the costs associated with your business' product that must be paid regardless of the volume of that product or service you sell. No matter how much you sell or don't sell, you still have to pay your fixed costs.
One obvious example of a fixed cost is overhead. Overhead may include rent for the space your company occupies, such as your office space. It may also include your weekly payroll. Depreciation on equipment is almost always considered a fixed expense.
Reducing certain fixed costs to improve your cash flow is possible, but may require decisions like moving to a less expensive workplace or reducing the number of employees. Other fixed costs, like depreciation, on the other hand, won't improve your cash flow but may improve your balance sheet.
if you're applying for a bank loan, for example, adjusting the depreciation schedule can improve your balance sheet. If you decide to change your depreciation schedule, be aware that:
- Slowing down the depreciation rate reduces your expenses on paper, but as a result, your IRS tax return will show an increase in profit. In other words, slowing down the depreciation rate will probably raise your taxes.
- You'll almost always need to get IRS approval to change an existing depreciation schedule. To do this, file IRS Form 3115, Application for Change in Accounting Method.
What Are Variable Costs?
Variable costs are directly related to sales volume. As sales go up, so do variable costs. As sales go down, variable costs go down. Variable costs are costs of labor or materials that change with sales. One way for a company to save money is to reduce its variable costs.
One way to reduce variable costs is by finding a lower-cost supplier for your company's product. Other examples of variable costs are most labor costs, sales commissions, delivery charges, shipping charges, salaries, and wages. Performance bonuses to employees are also considered variable costs. In many instances -- not always -- reducing variable costs are a little easier to manage without major disruptions than changing fixed costs.
Some costs have components that are fixed and some that are variable. One example is wages for your sales force. A portion of the wage for a salesperson may be a fixed salary and the rest may be sales commission. When calculating your fixed and variable costs, you should allocate the fixed portion to fixed costs and the variable portion to variable costs. Some depreciation methods that apply depreciation according to the asset's use may be variable or mixed costs -- partly variable and partly fixed.
Costs, Sales Volume, and Profit
A change in any of your costs affects your net profit. A change in sales volume almost always affects net profit as well because variable costs, such as materials costs and employee wages, inevitably rise with sales volume. On the other hand, even though your variable costs rise with sales volume increases, your unit costs may decline. If, for instance, you're buying production materials in greater volume you may be able to buy them at lower price points. Breakeven analysis shows the relationship between the price of the product you sell, the volume of the product you sell, and your costs or expenses. One of the variables you use in breakeven analysis, price, can be determined by further dividing up fixed and variable costs into direct and indirect costs. Direct costs are costs associated with the production of goods, such as hourly labor or materials. Indirect costs refer to costs that are not, such as rent and insurance.