Every business owner is well aware of how costs can impact the bottom line. After all, almost every aspect of business operations incurs some type of cost associated with it. These costs are a part of every business, but there are different categories of costs that can each have their own unique aspects. By understanding each of these various cost categories, a business can better manage these costs and look for ways to reduce them.
Below, we will look at some of the more common costs of business, such as variable costs and fixed costs. We'll also give some examples of each one to better help understand how each one can impact a business and its decisions.
The two main categories of expenses are often referred to as variable costs and fixed costs. So what is variable cost and how does it differ from a fixed cost? As the names suggest, a fixed expense represents those costs that generally remain constant over a given period of time, while the other represents costs that can vary.
These costs are generally ones directly associated with the production of goods or delivery of services. Let’s look at each of these separately.
So now that we know a variable cost is one that can change depending on production or delivery of services, let's look at some real life variable cost examples.
For this example, let’s use a business that ships products directly to consumers. As this business increases sales, the total cost of shipping materials, warehouse employees, and other items will increase. These costs are variable expenses because they change depending on production. But while these costs are going up, they are tied to overall sales. So while the cost may be increasing, sales or revenue are too.
However, in many cases, the overall costs can go up but the per-unit pricing can come down due to economies of scale or other buying factors. For example, buying more raw materials for production or buying larger quantities of shipping materials may yield lower per-unit pricing.
So, what is fixed cost and how does it differ from a variable cost? Well, the name says it all. A fixed expense or cost is one that stays constant regardless of the amount of production or services offered.
A fixed cost example would include the rent paid for office space, as it remains the same whether a business has a full list of clients or no clients at all. The same goes for a manufacturing company. The lease payments on machinery or equipment are the same and must be paid no matter how many products the company sells.
People sometimes confuse the fixed expense definition with that of a sunk cost, which refers to money that cannot be recovered. These two can sometimes be similar, but they are not the same thing. A fixed expense isn’t always a sunk cost (fixed costs can sometimes be recouped), and a sunk cost isn’t always a fixed expense. Let’s demonstrate this further with an example.
Let’s say a business owns real estate used for office space or manufacturing, but the owner decided to sell it because it was no longer needed. The real estate was a fixed cost, but it was not a sunk cost because the money put in was at least partially recovered. Knowing the difference is important for business owners who need to plan their expenses for the future.
Knowing the difference between these two expenses can help when it comes to managing a business, especially during expansion or other fluctuations. But how do you manage these costs in your day-to-day or month-to-month?
Variable costs are expenses that can be adjusted by exploring efficiencies or reducing waste in production. So while variable expenses scale with production, they are not locked to production rates. For example, if a company can eliminate waste and create the same amount of product with fewer raw materials, they have lowered the variable expenses to produce each product.
This is important when trying to maximize efficiency and reduce costs as variable expenses are one place to look first.
Fixed expenses are often harder to find savings in unless items or assets are given up, which may not be an option. For example, a business can downsize into a smaller office or facility, but this is often much more time-intensive and disruptive than finding efficiencies in their production or service delivery.
However, fixed costs on items that are no longer needed or can be combined with other items for cost savings should be explored.
Keeping a close eye on variable expenses can also help when planning seasonal changes or other fluctuations in business that occur regularly. Knowing how your variable expenses increase allows time to secure credit lines or other funding needed to deal with increases in costs that happen before money can be recouped from sales or services.
It’s not just important to know the difference between variable and fixed expenses — keeping detailed records is critical to overall business health. It helps spot wasteful spending or can help find areas to improve.
The expert team of accounts at Porte Brown can help any business better understand and track all of its expenses. From small businesses with an eye for growth to complex corporate infrastructures, Porte Brown’s outsourced accounting services can help you manage and track all of your business expenses for maximum efficiency and savings.
Get in touch today and find out how we can help you meet your objectives.
