When you operate a small business, you have two types of costs - fixed costs and variable costs.
Fixed costs do not change with the amount of the product that you produce and sell, but variable costs do.
A change in your fixed or variable costs affects your net income. It also affects your company's breakeven point.
What Are Fixed Costs?
Fixed costs are the costs associated with your business's products or services that must be paid regardless of the volume you sell. One example of a fixed cost is overhead. Overhead may include rent for the space your company occupies, such as your office space or your factory space. Here are the top five fixed costs in most businesses:
- Depreciation - the gradual deduction of an asset's decline in value. A physical asset is gradually expensed over time down to a value of $0.
- Amortization - the allocation of the cost of an intangible asset over a period of time. It is usually used to expense a mortgage loan down to $0.
- Insurance - the liability insurance you hold on your business.
- Rent - the rent you pay on your office, factory, and storage space.
- Utilities - electricity, water, and other utilities.
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 Internal Revenue Service (IRS) Form 3115 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 the costs of labor or raw materials because these items change with sales. One way for a company to save money is to reduce its variable costs.
Here are some examples of variable costs:
- Direct Materials - the raw materials that go into the production of your product
- Production Supplies - the supplies that are necessary for the machinery that help produce your product, such as supplies that help maintain your equipment
- Sales Commissions - the part of a worker's salary that is based purely on the sales they make
- Credit Card Fees - the fees that the merchant has to pay in order to offer credit card services to their customers
Other examples of variable costs are delivery charges, shipping charges, salaries, and wages. Performance bonuses to employees are also considered variable costs. In many instances, reducing variable costs are 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.
What is the Difference Between Costs and Expenses?
Costs are expenditures. Your company has expended resources to acquire an asset that it has not yet consumed. Examples are prepaid expenses, inventory, and fixed assets. An expense is a cost whose utility has been used up. For example, if you buy a van to use in your business, you depreciate it over time. When it is depreciated to zero dollars, it is fully expensed.
The same is true for amortization. If your business has a mortgage loan, it amortizes it over time until the loan is paid off and the principal and interest are down to zero dollars. At that time, it is fully expensed.
Costs, Sales Volume, and Profit
A change in any of your costs affects your net profit.
A change in sales volume 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. Price, which is one of the variables you use in breakeven analysis, 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 directly associated with the production of goods, such as rent and insurance.