When you look at your small business’s financial statements, there are likely a number of expenses on there. You have insurance premiums, the cost of raw materials, coffee runs, and numerous others.
While your expenses are likely all over the place, they can actually be broken into two categories most of the time: fixed costs and variable costs.
Basically, some operational costs are static while others fluctuate. Understanding what fixed costs are can help you in a big way, from creating a healthier cash flow to generally cleaner bookkeeping to overall reduction of business expenses. But, before we dive into the fun topic of expenses and how to rein in fixed costs, let’s look at what fixed costs are.
What are variable and fixed costs?
In business, not all costs are the same. Some expenses are all over the place, fluctuating depending on your company’s performance.
A good month could mean your expenses go up in certain areas but are outweighed by profit gains, while a bad month could see those same areas actually decrease because you’re not making or selling anything. As the old adage goes, sometimes you do have to spend money to make money.
To better understand how this works, let’s take a look at the two types of costs: fixed costs and variable expenses.
Fixed costs are exactly what the name implies: fixed. No matter how many products you have to manufacture or how much you sell, your fixed costs are always the same. For example, rent or loan payments stay the same regardless of your business activity.
Some of your fixed costs may be lumped into your overhead costs, such as rent or business insurance. But, this isn’t to say all overhead costs will be fixed.
Some overhead costs may change as your level of output increases or decreases. These costs are known as variable costs or variable expenses and fluctuate with your business activity. (More on those below.)
Fixed costs and budgeting
Specific costs are the easiest to budget, as they remain fixed throughout the financial year and tend to be predetermined.
Telephone and internet costs, for instance, can be packaged into monthly plans and paid in regular instalments. Insurance policies are set for the year ahead. Loan repayments are determined at the time the loan is paid down. Regulatory fees, such as business registration, are fixed in advance each year.
Because of their static nature, it’s easy to factor in your fixed costs first when budgeting for both short-term and long-term time periods. This is because you can quickly determine how much your monthly spending will be in terms of your fixed costs.
You know you have rent every month, as well as certain interest payments, insurance premiums, utilities, etc. Account for those first and you’ll be able to subtract that number from your monthly budget to see how much remains for variable expenses.
Speaking of variable expenses, what exactly are those?
Variable expenses, or variable costs, are at the opposite end of the spectrum from fixed costs. These expenses change depending on your company’s production, use of materials, and use of facilities.
For example, if you’re the business owner of a manufacturing company, your raw material costs will go up as your sales volume and production increase. You’ll also be spending more on direct labor, assuming you have employees who help you produce your products. There’s also the potential for indirect costs to increase with your production, like needing to pay more for security if your manufacturing location is open later.
All of these can be included under variable expenses, as the sum of each varies depending on your business activities. If your production increases or decreases, your total variable costs increase or decrease.
Variable expenses and budgeting
Budgeting for variable expenses is part art, part science, as these expenses can be all over the map. Fortunately, there are some strategies you can use to keep these oft-unpredictable expenses in line.
- Look ahead: There’s a good chance your company has a busy season. Think about when this season is and try to plan ahead for any increase in expenses, such as more materials or higher utility costs.
- Set hard limits for variable spending: While a variable expense can vary, you can still set a limit on it. Budget out what your maximum expenses can be for the month and set hard limits where you simply need to cut off certain variable expenses to stay viable.
- Audit your products: If you have certain products that simply cost too much to make compared to what they’re worth, it might be worth revising that product or scrapping it entirely.
Variable costs don’t have to be totally unpredictable. With some foresight and planning, you can get ahead of your variable expenses and understand what kind of monthly budgets are necessary during certain seasons.
Tips for reducing business expenses
You might be wondering how fixed and variable costs can be used to save you money. Both types of costs can actually be used to get a better hold on your spending and reduce the total cost of your business expenses. This can be accomplished by following these tried-and-true budgeting tips.
Cut what you don’t need
The beauty of fixed costs is that they’re fixed. You know what they are every single month. Look over your fixed costs and list them all out. Determine which costs are a must. These might be things like rent, insurance, essential software, or equipment you rent. These are things you have to keep.
Next, look at the remaining fixed costs and see if any of them seem extraneous. If you’re paying for software you no longer use, consider cutting it. If your monthly rent for your production facility is excessive and you don’t use a good portion of the space, think about relocating to a smaller facility or subletting part of your space.
It’s likely you have some fixed expenses you can cut, so dig deep.
Optimise your average variable cost
Variable costs aren’t as easy to prune as fixed costs because they fluctuate, but it’s not impossible.
Similar to the previous tip, list out all of your variable costs. Some examples of variable costs might include the cost of labor, credit card fees, and any costs in direct proportion to your production levels. (These could be raw materials, shipping costs for mailed orders, and so on.)
Next, think about what impacts the cost of each item listed. Sure, you need raw materials to make products. But, where are you getting those raw materials from? Have you recently shopped around for a better price? Is there a way you could optimise your production so you don’t need to have people work overtime?
While variable costs change depending on your production, you can have control over the base cost of each variable to an extent. Do some digging and see if you can find cheaper vendors, more efficient ways to create your products, better methods of shipping, and so on.
Be mindful of your break-even point
Your break-even point is the point at which your product profit equals the cost to make the item. To find this, use the following formula:
Fixed costs ÷ gross profit margin = break-even point
Your fixed costs, along with your gross profit margins, are a huge part of your break-even point, and as a result, a huge part of your company’s general cash flow and success. By understanding your break-even point, you can determine if your fixed costs are holding back your profits and business growth.
Set the right prices
If you feel you’ve already trimmed your fixed costs down as much as possible, think about how you can either reduce the cost of making your products or increase the price at which you sell your products.
It’s entirely possible your fixed costs are as low as they can go and your products are being made as efficiently as possible. If so, you may simply have to sell your products for more to meet your business’s budgetary needs. To ensure your prices are in the sweet spot, here are a few tips to follow.
- Routinely run competitor pricing checks. Take a look at what others in your space are charging. You want to be competitive, but you don’t want to be too cheap or too expensive.
- Raise prices without fear. Sometimes you simply have to raise your price to be competitive and drive a profit. Don’t be afraid, just raise it and monitor sales.
- Use pricing psychology. Understanding how your customers think about price can help you maximise how much people are willing to pay.
There are a number of pricing strategies you can use. When you understand them all, you can determine if you’re using the right one for your business.
Managing cash flow and keeping your budget in check are both intimidating tasks. But, by fully understanding your fixed and variable costs, you can make more informed decisions on whether you’re spending too much, charging the right price for your products, or going to need a major overhaul of your business budget.
Not long from now, you’ll be comfortable tackling fixed and variable costs, determining your break-even point, and reviewing cash flow statements with a smile.