Business expenses are categorized in two ways: fixed expenses and variable expenses. Fixed expenses or costs are those that do not fluctuate with changes in production level or sales volume. They include such expenses as rent, insurance, dues and subscriptions, equipment leases, payments on loans, depreciation, management salaries, and advertising. Variable costs are those that respond directly and proportionately to changes in activity level or volume, such as raw materials, hourly production wages, sales commissions, inventory, packaging supplies, and shipping costs.
Bookkeeping and accounting systems track activities by assigning each transaction to a particular account— phones, travel expense, materials purchase, etc … The accounts are all given a number of defining attributes and among those is a designation of fixed expense or variable expense. This is important because most business planning activities require that expenses be easily segregated into these two categories. Those managing businesses soon learn how crucial it is to track expenses in a way that helps to make planning, forecasting and bidding as easy as possible.
Although fixed costs do not vary with changes in production or sales volume, they may change over time.
As a result, fixed costs are sometimes called period costs.
Some fixed costs are incurred at the discretion of a company’s management, such as advertising and promotional expense, while others are not. It is important to remember that all non-discretionary fixed costs will be incurred even if production or sales volume falls to zero.
Although production and sales volume are the main factors determining the level of variable costs incurred by a company, these costs also may fluctuate in relation to other factors, such as changes in suppliers’ prices or seasonal promotional efforts. Some expenses may have both fixed and variable elements. For example, a company may pay a sales person a monthly salary (a fixed cost) plus a percentage commission for every unit sold above a certain level (a variable cost).
It is important to understand the behavior of the different types of expenses as production or sales volume increases. Total fixed costs remain unchanged as volume increases, while fixed costs per unit decline. For example, if a bicycle business had total fixed costs of $1,000 and only produced one bike, then the full $1,000 in fixed costs must be applied to that bike. On the other hand, if the same business produced 10 bikes, then the fixed costs per unit decline to $100. Variable costs behave differently. Total variable costs increase proportionately as volume increases, while variable costs per unit remain unchanged. For example, if the bicycle company incurred variable costs of $200 per unit, total variable costs would be $200 if only one bike was produced and $2,000 if 10 bikes were produced. However, variable costs applied per unit would be $200 for both the first and the tenth bike.
The company’s total costs are a combination of the fixed and variable costs. If the bicycle company produced 10 bikes, its total costs would be $1,000 fixed plus $2,000 variable equals $3,000, or $300 per unit.
It is very important for small business owners to understand how their various costs respond to changes in the volume of goods or services produced. The breakdown of a company’s underlying expenses determines the profitable price level for its products or services, as well as many aspects of its overall business strategy. A small business owner can use a knowledge of fixed and variable expenses to determine the company’s break-even point (the number of units or dollars at which total revenues equal total costs, so the company breaks even), and in making decisions related to pricing goods and services.
Economies of scale are another area of business that can only be understood within the framework of fixed and variable expenses. Economies of scale are possible because in most production operations the fixed costs are not related to production volume; variable costs are.
Large production runs therefore “absorb” more of the fixed costs. An example is a printing run. Setting up the run requires burning a plate after a photographic process, mounting the plate on the printing press, adjusting ink flow, and running five or six pages to make sure everything is correctly set up. The cost of setting up will be the same whether the printer produces one copy or 10,000. If the set-up cost is $55 and the printer produces 500 copies, each copy will carry 11 cents worth of the setup cost—the fixed costs. But if 10,000 pages are printed, each page carries only 0.55 cents of set-up cost. The reduction in cost per unit is an economy due to scale.
Determining the fixed and variable expenses is the first step in performing a break-even analysis. The number of units needed to break even = fixed costs / (price variable costs per unit). This equation provides a small business owner with a great deal of valuable information by itself, and it can also be changed to answer a number of important questions, like whether a planned expansion will be profitable. Knowing how to work with information about fixed and variable expenses can be particularly helpful for individuals who are considering buying a small business. Many businesses, particularly franchises, are reluctant to give out information about projected profits, but will provide information about costs and unit prices. The potential purchaser can then use this information to calculate the number of units and the dollar volume that would be needed to make a profit, and determine whether these numbers seem realistic.