Every business has to spend money in order to make money. Business expenses are known as "costs" and can be separated into two main categories for bookkeeping purposes. Fixed costs, also known as overhead costs, do not depend on production volume. Variable costs, on the other hand, increase or decrease in relation to the number of units produced by the company or the number of clients served.
A common misconception about fixed costs is that they never change. In fact, fixed costs can and do change but typically over a period of time and never due to changes in production or service. Instead, they change due to reasons outside of the business owner's control.
When creating a cash-flow statement or projected-income statement, it's important to understand that not all costs are created equal. Understanding the distinction between these two categories will help you make more accurate cost-accounting estimates. You can then calculate the total cost by adding the total fixed cost to the total variable cost.
TL;DR (Too Long; Didn't Read)
Fixed costs stay the same from period to period regardless of the quantity of output (i.e., number of clients served or products manufactured). Rent payment is an example of a fixed cost.
Common Fixed-Cost Examples
Rent or lease payments and loan payments represent a major fixed cost for many businesses because the landlord or bank expects the same amount each month. Salaries and employee wages are also a fixed cost. Even if the machines in your factory go down and your unit of output is zero for an hour, you still need to pay employees for their time. The same is true if you own a retail store because you still need to pay someone to be present even if no customers walk through the door.
Utilities such as electricity, gas and water represent fixed expenses when they aren't used directly for manufacturing a product or providing services to customers. For example, the electric bills for an office may ebb and flow only with the seasons, whereas the water bill for a dog groomer will directly correlate with the number of dogs bathed during the billing period.
Business owners who work outside of a traditional brick-and-mortar space can also have fixed costs. For example, the bookkeeping and project-management software used by a general contractor may have a monthly or yearly subscription fee. Business websites require web hosting and domain-name registration, which will be billed periodically.
Common Variable-Cost Examples
Examples of variable cost include anything that is directly related to the manufacturing process or that depends on how many clients are seen in a day. For example, the amount of gasoline that plumbers put in their trucks depends on how many clients they'll see. More clients means more driving, which means more gas.
Other raw materials also represent variable costs. How much cotton should a bath-towel factory purchase this week? It completely depends on how many bath towels they plan to produce.
Any wages that are based around a production or sales amount (such as commissions) also fall under variable costs.
Short-Term vs. Long-Term Fixed Costs
Some fixed costs can be expected to change over time, making them fall into a gray area that's fixed in the short term but variable in the long term. For example, insurance premiums often increase a little each year, and property taxes rise when the appraised value goes up. Your employees will also expect a raise for their hard work, which means salaries and hourly wages will increase over time.
You can handle this by looking at cost accounting in smaller periods. For example, a three-year projected-income statement or cash-flow statement will make it difficult to account for these adjustments in fixed costs. Try looking at fixed expenses for just one year instead.
Arbitrary budgets, such as money set aside for advertising, can also be fixed for a short-term period and increase over time depending on performance. If an advertising campaign proves successful at increasing sales, some of the profit can be reinvested back into the advertising budget, making it a variable expense.
Pros and Cons of Fixed Costs
Variable costs give business owners an opportunity to reduce their spending if needed. If the bath-towel factory can't afford the raw materials required to run the factory at full capacity, then production can be scaled back to accommodate what is possible. Fixed costs don't allow this type of flexibility, which is one major drawback of having high fixed costs.
However, because fixed costs remain the same despite the production output, it can be cheaper in the long run to produce a larger quantity of products or to serve a greater number of people. This is known as economies of scale. An increased production volume leads to an increased number of units for the price of each variable cost per unit plus the total fixed cost.
By definition, those fixed costs don't increase along with the increased production volume. Therefore, the total cost per unit decreases as more and more units are made.
How to Reduce Fixed Costs
However, until you reach that exciting point in which the economies of scale work in your favor, it may be necessary to reduce fixed costs as much as possible. You can start by taking a look at other properties in the area to see if you're overpaying on rent. A move might pay off in the long run.
Think about whether you need a brick-and-mortar location in the first place. With cloud-based technology making communication and organization easier than ever, you and your team might accomplish just as much from your respective home offices. This change would significantly reduce your overhead costs.
You can also look into restructuring your loan repayment plans, investigate cheaper insurance carriers, adjust the employee schedule or cut out departments that aren't necessary at this stage in your company's growth. For example, if you created an in-house marketing team but don't have any money left to fund marketing campaigns, you might be better off outsourcing to an agency that can put in as many or as few hours as you can afford that week.
Example of Fixed Costs and Economies of Scale
Consider a food truck that sells sandwiches. The business owner, Tom, has calculated that the total variable cost associated with one sandwich is $2. Tom has also determined that his average fixed cost for his small business is $1,500 each month.
Tom knows that he can easily sell 2,000 sandwiches per week. At this rate of production, Tom has spent ($2 X 2,00) + $1,500 = $5,500 per month. This comes out to a cost per unit of $2.75. If Tom ramps up his sales to 2,500 sandwiches per month, the cost per unit lowers to $2.60.
It may only be a 15 cent difference on paper, but it adds up to a total cost savings of $375 per month for Tom, and he didn't have to do anything particularly fancy. He earned money and saved money by simply increasing his quantity of output — in other words, making more sandwiches.