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Variable versus Fixed Costs: Why You Need to Know the Difference

In this chapter, you will learn —

• How to classify your business’s expenses into fixed or variable expenses

• How costs behave when your production volume changes

• Why “losing money on every unit but making it up on volume” doesn’t work

• How to determine your business’s capacity

Let’s take a look at cost behavior, that is, finding out how particular costs are affected by events such as changing sales levels, increases or decreases in other costs, and the purchase of new assets.

At first glance, it may appear that this kind of analysis of your financials is time consuming and boring, but all successful and long-lasting businesses understand cost behavior. This will help you better understand the mechanics of your business and will allow you to plan for growth with confidence.

Case Study

Becky frowned and rubbed her temples. “Vivian, how can I tell when we need to hire an employee? Shouldn’t I be able to see how much work the new employee has to bill out to be able to afford him?”

Vivian smiled. “Absolutely. Do you know what your break-even point and capacity are right now in the company?”

“Not only don’t I know those things, I don’t even know what they mean!”

“Your break-even point is the amount of revenue you need to bring in to keep the doors open. In other words, it is the amount of billings that covers the fixed expenses of the business. Your new employee, for example, would be a fixed cost,” Vivian said. “Capacity is the total amount of work that you can do with the resources you have. When Joe is working by himself, he can only bill out so many hours. With a new employee, that capacity doubles. Understanding these two key concepts allows you to analyze any changes you might want to make in your cost structure.”

Fixed versus Variable Expenses

Your business’s expenses can all be categorized by their behavior, that is, by whether or not they vary with the level of your business’s revenues. The expenses on your income statement are either fixed or variable.

Variable expenses

These expenses vary directly with the sales revenue of the business. The most common examples of variable costs are cost of goods sold (in the case of a retailer) and cost of goods produced (in the case of a manufacturer).

Let’s say you sell a product for $10 a unit and your cost to purchase that unit is $8. Your variable cost is $8 a unit. (The cost is variable because it depends on how many products you sell.) Therefore, if you have $1,000 in sales, your cost of goods sold is $800. If you have $100,000 in sales, your cost is $80,000. The cost of goods sold will always vary in a direct relationship with sales volume.

The only way to change variable costs is to do one of the following:

• Renegotiate your purchase contracts with your goods or materials suppliers

• Purchase cheaper product (although, that may very well have an impact on how much you can sell the product for)

• Purchase in greater volume to get higher purchase discounts (although, you may also have a higher cost of warehousing your inventory)

Fixed expenses

These are expenses that are independent of the sales volume. This means that even if you do not sell $1 worth of your product or service, you will still incur these costs.

Rent, utilities, and office wages are some examples of fixed expenses. Whether or not you are selling anything, you still need a place to run your business, to have lights on, and to pay someone to answer the telephones.

It’s important to note that fixed expenses are only fixed in the short run. Eventually, when your sales volumes increase, you will need a larger warehouse, more power for the equipment, and more office staff. However, for the time being, we will only look at the range of sales volume in which the fixed expenses remain constant.

Why is Cost Behavior Important to My Business?

So, why do you need to know how your costs behave? Because, armed with that information, you can analyze your income statement and plan for business growth. Two critical concepts fall out of cost behavior analysis: break-even point and capacity.

Break-even point

Your business’s break-even point is the point where your revenues are sufficient to cover your expenses. Remember, even if you don’t sell anything, you still have fixed costs to cover.

Consider the following example:

Revenue per unit — $10

Cost per unit — $7

Gross margin — $3

So, for every unit you sell, you net $3. Now, what if your fixed expenses looked like this:

Rent — $7,500

Utilities — $1,250

Wages — $9,470

Office supplies — $595

Total fixed expenses — $18,815

How many units would you have to sell to cover your fixed expenses?

$18,815 ÷ $3 = 6,272 units

You would need to sell 6,272 units to keep the doors open. If you sell more, you make a profit. If you sell fewer, you will lose money.

Instead of looking at the number of units you need to sell to break even, you can also calculate the total sales you need to make. Using the above example, we would start by calculating a gross margin percentage (gm%).

GM% = GM per unit ÷ Revenue per unit = $3/$10 = 30%

Break-even sales would then be —

Overhead/GM% = $18,815 ÷ 0.30 = $62,717

You would therefore need to have revenues of $62,717 to be able to keep the doors open.

Most small businesses never take the time to calculate their break-even point. Most feel that their revenues will be whatever they are and that they can’t do anything about them. You can see from the above example why it would be important to know how much your sales have to be in order to survive.

Capacity

Not only is it important to know how much you need to sell in order to keep the doors open, you need to know how much you can do in sales with your current fixed cost structure. This is called capacity. If you’re a manufacturer, your plant and equipment will only physically handle so many units before you need to move to a larger premises and purchase new equipment. If you’re in a service business, as your revenue levels start to increase, you will need to hire more staff and have larger offices.

Think of the break-even point as the minimum you need to do and capacity as the most you can do.

For example, let’s look at a business that manufactures dolls. The business has a combined plant/warehouse and employs 35 manufacturing staff. The owner has analyzed the equipment, space, and staff, and has determined the following:

Maximum units manufacturing equipment can produce — 12,500

Maximum units warehouse can store — 10,475

Maximum production of manufacturing staff — 14,675

This analysis tells us that the warehouse space is the limiting factor, or the bottleneck, in the business. No matter how hard the staff work or how hard the equipment is run, the warehouse can only handle 10,475 units. This is the capacity of the current cost structure.

Why is this important information? If the owner is budgeting and forecasting for the upcoming year and budgets any more than 10,475 units to be produced, she must also plan for more space — which increases her fixed costs. She would then have to determine whether the profit from the additional units offsets the new cost of larger warehousing space.

This concept is also valid for service businesses. Let’s assume your business provides consulting services. You are the owner and chief consultant and you have two other consultants working with you.

Case Study

“So, based on my calculations,” Becky said, “we would need to make sure that the new employee has at least 20 hours of billable work a week in order to pay for his salary.”

“That’s right,” said Vivian. “And you were telling me that, with your expected increase in commercial construction work, you should easily be able to get the 20 hours. So it makes sense to hire an employee.”

“I’ll get the ad in the paper today,” said Becky.

You want to calculate your capacity. Look at the following figures:

Number of hours in a work year (per person) — 1,950

Average number of hours spent on admin. activities — 250

Number of hours available to charge to clients — 1,700

Average charge-out rate — $75

Each of the three consultants should be able to charge out 1,700 times $75 annually to clients. This is then multiplied by the number of consultants:

1,700 X $75 X 3 = $382,500

This means that the maximum revenue with your current cost structure is $382,500. It would be ridiculous to budget for revenue of $500,000 without planning for a new staff member.

Chapter Summary

• Fixed costs are costs that do not change with volume of sales.

• Variable costs are costs that do change with changes to the sales volumes.

• The break-even calculation tells you how much of your product or service you have to sell in order to cover your fixed costs.

• The capacity calculation tells you the maximum number of units of your product or service you can produce or provide with your current operating facilities.