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Understanding Fixed & Variable Costs for a Small Business

Understanding Fixed & Variable Costs for a Small Business

When you run a small business, you have two costs: fixed costs and variable costs.

Fixed costs don't change based on how much product you make and sell, but variable costs do.

A variation in fixed or variable costs affects the business' bottom line. It also affects the profitability of your business.


What are fixed costs?

Fixed costs are costs associated with products or services in your business that must be paid for in spite of the quantity you sell. An example of a fixed cost is indirect costs. Indirect costs can include renting space for your business, such as an office or factory. Here are the top five fixed costs for most businesses:

  • Amortization: the distribution of the cost of an intangible asset over a period of time. This is usually used to charge a home loan of up to $0.

  • Depreciation: progressive deduction of the decline in value of an asset. A physical asset gradually wears out over time to a value of $0.

  • Insurance: The liability insurance you have for your business.

  • Rent: The rent you pay for the office, factory, and storage space.

  • Utilities: electricity, water, and other utilities.

Some fixed costs can be reduced to improve cash flow, but this may require decisions like moving to a cheaper workplace or reducing the number of employees. On the other hand, other fixed costs, like depreciation, won't improve your cash flow, but they can improve your balance sheet.

For example, adjusting your repayment schedule can improve your balance sheet if you are applying for a bank loan. If you choose to change your depreciation schedule, please note that:

  • A lower depreciation rate will reduce paper costs, but as a result, the IRS yield will show increased profits. In other words, lowering the depreciation rate is likely to increase taxes.

  • You will almost always need to get IRS approval to change an existing amortization schedule. To do this, submit Form 3115 (Change in Accounting Methods) to the Internal Revenue Service (IRS).


What are variable costs?

These are costs that are directly related to sales volume. As sales increase, variable costs also increase. When sales go down, variable costs go down. You can also consider it as costs of labor or raw materials, as these items change with sales. One way for a business to save money is to cut variable costs.

Here are some examples of variable costs:

  • Credit Card Fees: A merchant must pay fees to provide credit card services to their customers.

  • Direct materials: the raw materials used in the manufacture of your product

  • Production Consumables: Consumables needed by machines that contribute to the product's manufacture, such as equipment maintenance consumables.

  • Sales commissions: the part of a worker's salary that is based exclusively on the sales he/she makes.

Other variable costs are shipping charges, transportation costs, wages, and salaries. Employee performance bonuses are also considered variable costs. Reducing variable costs is straightforward to manage without major disruption than changing fixed costs in many cases.


Semi-Variable Costs

Some costs have fixed components, and some have variable components. An example is the salaries of your sales force. Part of a salesperson's salary can be a fixed salary, and the rest can be a sales commission. When calculating fixed and variable costs, you must assign the fixed part to the fixed costs and the variable part to the variable costs.


What are the dissimilarities between expenses and costs?

Costs are expenses. Your business has spent resources on acquiring an asset that it has not yet consumed. Examples are prepaid expenses, inventories, and fixed assets. An expense is a cost whose usefulness has run out. For example, if you buy a truck for your business, you depreciate over time. When it depreciates to zero dollars, it is fully spent.

The same goes for amortization. If your business has an amortization, it is repaid over time until the loan is paid off and principal and interest are reduced to zero dollars. At that point, it is completely liquidated.


Sales Volume, Costs, and Profit

A change in any of your costs affects your net income.

A change in sales volume will always affect net income, as variable costs, such as material costs and employee salaries, inevitably increase with sales volume.

On the other hand, while the variable costs increase with the sales volume, the unit costs may decrease. If, for example, you buy materials in bulk, you can buy them at lower prices.

The break-even analysis shows the relationship between the volume of the product you sell, the price of the product, and your costs. Price, one of the variables you use in your break-even analysis, can be determined by the additional breakdown—the value of price and variable costs into direct and indirect costs. Direct costs are the costs associated with the production of goods, such as hourly labor or materials. Indirect costs refer to costs not directly associated with the production of goods, such as rents and insurance.


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