Understanding Costs: Fixed vs Variable
Running a business requires a thorough understanding of money coming in, as well as the money going out. Sometimes, business owners forget to analyze expenses to ensure they're not leaving any of their hard-earned revenue on the table. To better comprehend expenses, let's break them down into two categories: variable and fixed costs. Variable costs fluctuate with the level of production or sales, while fixed costs remain constant regardless of business activity. Understanding the differences between these cost types is essential for comprehending the profitability of each product, identifying which costs contribute to generating more revenue, and which ones do not. By gaining a deeper understanding of these cost classifications, you'll be better equipped to make informed decisions, optimize your business operations, and drive profitability.
Fixed Costs
To understand fixed costs, let's imagine that your business doesn't sell any products or services for a whole month (although this would be bad news, let's pretend). At the end of the month, the only expenses you would see on your P&L statement would be your fixed costs. Rent, insurance, salaries, and internet are a few of the most common fixed costs that businesses have. The good news is that if your business has a good month, your fixed costs likely won't increase. On the other hand, if the business has a bad month, fixed costs won't go down. By understanding what your fixed costs are and how they affect your revenue, you can take a closer look at them and decide in which areas you can save some money.
Variable Costs
Variable costs are expenses that result from selling a product or a service. If you sell a product to a customer, you might incur shipping costs, sales commissions, manufacturing labor, and others depending on the nature of your business. Before offering a product to customers, it's important to understand the profit margin of that product, which can only be accurately calculated if you truly understand the variable costs associated with selling that product. Sometimes, your variable costs will fluctuate depending on the current cost of shipping, raw materials, and labor costs. To mitigate this uncertainty, it’s important to record assumptions made while calculating variable costs and add some wiggle room for inflation and rising costs. This is an effective way of managing the profitability of your products and your business.
A comprehensive understanding of costs and their nature is crucial for running a successful business. By categorizing costs into variable and fixed, business owners can gain valuable insights into profitability, break-even points, and other metrics. Fixed costs, such as rent, insurance, and salaries, remain constant regardless of business activity, highlighting the importance of managing them effectively to maintain financial stability. On the other hand, variable costs are directly tied to the sale of products or services and require careful analysis to determine accurate profit margins. By recognizing the impact of both cost types on revenue, business owners can identify areas for potential cost savings and make strategic adjustments to enhance their overall financial performance.