Not all expenses are the same and it’s important to understand how they differ in order to effectively manage your business and increase profitability. In general, all of your expenses can be placed in two main categories: fixed costs and variable costs.
These costs remain consistent regardless of your revenue. In other words, even if you don’t record a single sale, you still need to pay these expenses. They include items such as rent, insurance, management salaries, phone, utilities, loan payments, and advertising.
Identifying all fixed costs and understanding what percentage of your cost structure they make up is important. If your business has a high fixed cost structure and is cyclical/seasonal, you may find it difficult during periods of lower sales because a relatively high number of expenses still need to be paid. Many companies seek to reduce their overall fixed costs through careful review and flexible pay-for-use arrangements. Covering fixed costs is a necessary fundamental in order to keep your business alive.
These costs respond directly to changes in sales. Examples of variable costs are direct salaries & wages, supplies, and commissions. Identifying your business’s variable costs is important for several reasons. Variable costs: need to be considered when establishing prices (you want to ensure your sales are profitable), enable you to calculate your profit margin, and provide insight into comparative financial analysis. If your variable costs exceed your revenues you’re never going to generate a profit or be able to cover what fixed costs you may have.
The goal of any business is to cover fixed costs and profit from increased sales volume. Increasingly, businesses are trying to reduce fixed costs and move toward a cost structure that includes a relatively higher level of variable costs. This ensures that if costs are incurred, revenue has been generated in association with those costs. Significant fixed costs can be difficult to manage, particularly if your business is seasonal. By understanding the cost structure of your business you can effectively manage, plan and increase your business’s profitability.