Variable & Fixed Costs
Understanding whether a cost is fixed or variable will help business owners and CEOs understand the impact that each expense has on the performance of the firm. It is imperative that companies understand their unique cost structure. Doing so will create a competitive advantage.
In addition, correctly segregating a company’s costs empowers the owners to make the right pricing decisions for their products and services. This information also helps a company know its break-even and profit maximization points.
Variable costs grow and shrink in correlation with the sales revenue of the firm. Some variable costs are not perfectly proportional to sales. Variable costs that can only be obtained in large chunks are called step-variable costs. Labor is usually only available in large chunks. Imagine you have one employee assembling widgets. When you hired the employee on salary, you only had 30 hours of work for them each week. As you grew, the employee’s time grew to in excess of 40 hours per week. Notice that the cost of the salary stayed the same, even though sales volume increased. When you hire a second salaried employee, you might have a total of 60 hours per week for both of them to do. Your costs immediately step-up to the salaries of both employees even though your sales did not grow proportionally.
Fixed costs do not change – they stay the same. An example of a fixed cost is the rent that a movie theatre pays each month. Regardless of the number of people who come to see a movie that month, the company will pay the same fixed amount for rent. Committed fixed costs include a long-term contractual promise to pay the fixed cost, like a long-term lease on a warehouse. Discretionary fixed costs are typically decided by the owners and managers of a company in the form of an annual budget or monthly strategy. Advertising is a good example.
Not all cost categories are equal. In addition to fixed and variable expenses, some costs are mixed. This means that some element of the cost is fixed and another element is variable. This is common with insurance policies in which a minimum premium must be paid regardless of sales or payroll volume, but some part of the premium is variable based on company growth.
Our CFO advisor have been helping companies understand their cost structure for many years. More importantly and as a result of these efforts, we have helped many companies correctly price their products and use their cost structure to gain a competitive advantage in their respective markets.