Fixed and variable costs relate to both business and personal finance. Although they lie at opposite ends of the spectrum, they both focus on expenses and are necessary in determining the potential for profit. Much of the effectiveness of a business or personal financial plan depends on how well you can control these types of expenses.
Fixed Cost Identification
Fixed costs compare to a long-term commitment. Whether in a business or personal sense, fixed costs remain constant despite the economic environment, annual sales or your annual salary. These include overhead expenses or costs such as rent, a mortgage payment, property taxes, insurance premiums, administrative salaries or any other cost over which you have no control. The only relationship fixed costs have to income is in the percentage of your income it takes to cover these costs. If your income is high, fixed costs appear to consume less of your income, while if your income falls, fixed costs can put you out of business or drive you to bankruptcy.
Variable Cost Identification
Variable costs are flexible costs that rise and fall according to the economic environment or actions you take. These include costs such as raw materials, sales or production salaries, product inventory, utilities, services, food or fuel expenses. You have, for the most part, a high level of control over variable costs. For example, you can reduce your sales staff if sales start to fall, reduce or increase inventory levels as necessary, become energy efficient or cancel your cable television subscription to save money.
As they relate to business, the difference between fixed and variable costs can help you determine a break even point, or the point at which you will begin realizing a profit. A break even analysis is a common step business owners take when completing a feasibility study for a new business or product. The formula that helps you determine the level of sales necessary for a profit requires that you first determine the average per unit sales price for the new product. Then, you divide an average of your annual fixed costs by the sum of 1 minus the average per unit variable cost divided by the average per unit sales price. For example, if your average annual fixed costs are $60,000, the average per unit sales price is $5 and the average per unit variable cost is $2.80, you will need to $136,365 in gross sales ($60,000.00 divided by 1 minus ($2.80 divided by $5) equals $136,365) to break even.
One way to help keep costs under control is to avoid taking on fixed costs altogether, or turning fixed costs into variable costs. In a business, you can accomplish this by eliminating employee health insurance, consolidating business locations, or outsourcing, for example, your customer service department. At home, consider downsizing to achieve a smaller, more affordable rent or mortgage payment, review insurance policies to make sure you are not over insuring your home, car or life and review property tax bills with an eye toward dispute if you feel the assessment is in error.