How to better understand your business' fixed and variable costs

09 October 2020

Business costs are a critical component in the day-to-day of commerce and trade that all organisations must manage. Even if business is good and you’re amassing a sizeable revenue, a lack of knowledge when it comes to managing costs can lead to a dip in profits. Therefore, understanding the different types of costs that can be incurred can help you to run your own business more effectively.

Although it can be difficult to keep an eye on expenditure as your business grows, it’s important to avoid short-term cost-cutting measures as a means of managing them if they start to mount.

Here, we’ll investigate the various types of costs that SMEs face, how these costs can be classified, and some practical tips for managing them in an effective long-term manner.

 

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The different types of business costs

An integral aspect of business improvement, establishing an accurate costing system serves to identify your most profitable products and services, allowing you to see which revenue streams may be costing your business more than the revenue generated. Therefore, your costing analysis can be used as a means of deciding which products or services to focus on and which to drop.

And though categorising your costs helps to determine accurate costing in order to manage them more effectively, how do the varying types of cost differ from one another? We'll take a look in the next few sections below.

 

What are fixed costs?

Fixed costs are the costs associated with your business’ product that must be paid regardless of the volume of sales. So, whatever you sold and whatever you have remaining, you still have to pay your fixed costs. They do not change even if the company’s sales volumes or production levels increase, so there’s no need for any additional calculations.

Examples of fixed costs

Your business overheads are prime examples of fixed costs. These include costs such as rent for your office space, weekly payroll, marketing and advertising and equipment leases.

How to calculate fixed costs: A formula

Your business' fixed costs can be calculated using the below formula:

Fixed Cost = Total Cost of Production – Variable Cost Per Unit * No. of Units Produced

 

 

What are variable costs?

In comparison, variable costs are directly related to sales volume. As sales go up, variable costs increase accordingly, and vice versa.

Examples of variable costs

Consider a business that produces and ships goods. The more goods being produced and shipped, the more it will have to spend on materials, supplies and transportation. Similarly, if a business accepts credit cards or uses payment processors, a small percentage of each sale goes to the bank or processor for facilitating any transactions. Therefore, you’ll incur a variable cost since the amount you pay in merchant fees depends on your sales.

How to calculate variable costs: a formula

Your business' variable costs can be calculated using the below formula:

Total Variable Cost  =  Total Quantity of Output x Variable Cost Per Unit of Output

 

 

What are mixed costs?

Mixed costs, or semi-variable costs, are those which have an inherent element of both fixed and variable costs. They vary with sales volume, but are not directly proportional to them.

An example of mixed costs

Consider something like a phone bill; the fixed part of this comes in the form of line rental, while the variable component is the call charges that come with frequency of use.

How to calculate mixed costs: a formula

Your business' mixed costs can be calculated using the formula below:

Total Mixed Cost = Variable Cost + Fixed Cost

 

 

Why is it important to distinguish between fixed costs and variable costs?

As a small business owner, tracking and understanding how various costs change in their volume and output levels is vital. The breakdown of these expenses determines the price level of the services and assists in many other aspects of the overall business strategy. Such costs are the main elements that businesses use for various costing methods, including order, process and activity-based costing.

Break-even analysis

Knowledge of fixed and variable expenses is essential for identifying a profitable price level for services. This is done by performing a break-even analysis, which uses the following formula:

Volume needed to break even = fixed costs / (price - variable costs)

This equations illustrates valuable information about pricing but can also be modified to answer other important questions, such as how feasible expansion may be. It's also useful in showing info for projected profits. If an entrepreneur is considering buying a small business, then the formula helps them calculate what's needed to make a profit, deciding from there whether these numbers seem credible.

Economies of scale

Fixed and variable expenses also help to identify economies of scale. This cost advantage is established in the fact that as output increases, fixed costs are spread over a larger number of output items.

 

Classifying business costs 

  • Direct and indirect costs

In addition to the above, there are direct and indirect costs which affect the classification of business costs. For budgeting and accounting purposes, it’s essential that you classify your costs into these two distinct categories.

Direct costs are traceable to the production of a specific good or service. They can be connected to a ‘cost object’ such as a product, department or project, specifically items such as software, equipment and raw materials. Labour, assuming it is specific to the product, department or project, is also included. 

Imagine the following scenario: an employee is hired to work on a project, either exclusively or for an assigned number of hours; the labour of this project constitutes a direct cost. The majority of direct costs are variable, they increase because additional units of a product or service are created. An exception is direct labour costs, which are usually fixed and remain constant throughout the year.

Indirect costs, meanwhile, relate more to the maintenance of the company as a whole, rather than a specific product. After direct costs have been calculated, these are the overhead costs that are leftover. For example, things required by the company to operate on a day-to-day basis constitute examples of indirect costs, such as office equipment rental, phones and desktop computers. They contribute to the company as a whole, rather than being assigned to the creation of any one service.

The same goes for labour that supports the company as a whole, rather than employees that serve something specific. Additionally, costs such as advertising and marketing, communications, and employee benefits, along with accounting and payroll services fall under the umbrella of indirect costs.

They can be both fixed and variable in nature. Fixed indirect costs include the rent for office space, while variable indirect costs can come in the form of fluctuating gas and electricity prices.

 


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They can be both fixed and variable in nature. Fixed indirect costs include the rent for office space, while variable indirect costs can come in the form of fluctuating gas and electricity prices.

 

Best practices for reducing and managing costs

However big a business is, it’s possible that they’re spending money on items that simply do not have an impact on their customers or their business operations. Rather than cost-cutting measures that only work in the short-term, the onus for businesses should be on pro-active and effective cost management that offers positive effects in the long term. Use the following best practices if you're looking to keep an eye on your spending.

  • Look at simple changes first

From the outset, you can make some fairly straightforward changes without risking the quality of your service in a significant way. Check your supplier invoices for any discrepancies, for example. If you’re heating your premises or leaving lights on during downtime, then make sure they’re switched off. Get rid of unnecessary items such as telephones that aren’t being used, and if you post things often, only use first class post when it’s absolutely necessary.

  • Review and understand your business’ cost-revenue structure

This one is crucial. If you want to manage your costs, then you must identify where your revenue is coming from. For example, which products and services are producing the most sales, or which customers spend the most on your business,? The company must then work out which specific costs are producing this stream of revenue before identifying overheads and costs that aren’t directly linked to revenue generation.

  • Review your vendors regularly

Annual or semi-annual reviews of key vendors should become standard practise if you’re looking to manage costs. If possible, make sure automatically renewing contracts are flagged up for review 60 to 90 days before their renewal.

  • Get employees involved in decision making

Employees should be trained up in a way that lets them better control their costs. Getting them involved with decision-making, team-building and problem-solving is a great way of letting them know they’re being invested in. When faced with certain situations, they’ll be able to suggest answers together as a team as a more fiscally-minded workforce.

To this end, you have to practice what you preach, as this can send both a positive and negative message to your employees. Be mindful of the choices you make and actions you take when it comes to spending money.

Gazprom Energy is a leading and award-winning business energy supplier, helping thousands of small businesses manage their gas and electricity contracts. To find out more about what we can offer your business, visit the homepage or call us today on 0161 837 3395.

 The views, opinions and positions expressed within this article are those of our third-party content providers alone and do not represent those of Gazprom Energy. The accuracy, completeness and validity of any statements made within this article are not guaranteed. Gazprom Energy accepts no liability for any errors, omissions or representations.


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