Managing fixed and variable expenses should be a priority for every company, but nearly 82% fail due to cash flow problems. Knowing the difference between these costs and how to decipher them on financial statements is the best way to figure out how to manage fixed vs variable and increase profit margins.
Fixed costs are predetermined expenses that remain constant regardless of output levels. These expenses are often referred to as indirect costs or overhead expenses. However, fixed expenses are generally recorded as operating costs on income statements and balance sheets. Think of fixed expenses as the price of running a business. Bills for rent and insurance will keep coming in even during a temporary closure.
Variable costs are business expenses that change according to production and sales volume. These expenses are essentially the amount of money spent to produce and sell products or services. The more you produce, the more you pay, and vice versa. Variable expenses appear on an income statement under cost of goods sold (COGS). This includes labour costs and raw materials.
Some companies may spend 90% of monthly expenses on fixed costs and 10% on variable costs. For others, it may be the other way around. Regardless of the ratio, both impact profit margins. Controlling fixed and variable costs starts with knowing which expenses fall into which categories. Here are some common examples of fixed vs. variable expenses.
Fixed costs stay the same month to month, which makes them more predictable. However, this predictability also means that fixed expenses are hard to change since they're tied to business operations—like rent or insurance payments.
When analyzing fixed costs, companies should determine the break-even point. This is the point when costs are equal to revenue. On average, it takes companies 2-3 years to make it past the break-even point. There are a few ways to manage fixed expenses and make it over the break-even hurdle.
Selling products or services with higher margins is another way to reduce fixed costs without cutting any expenses. Building up cash reserves or setting up a line of credit can also help offset slow periods when cash flow is strained.
Variable costs are usually cut first when companies want to increase profits. Reducing variable expenses will lower the costs of producing a product or service. In other words, you get to keep more revenue as income.
Even though making more money is the ultimate goal, reducing variable expenses shouldn't cut corners on quality. Losing business because of a dip in quality will end up erasing any savings from variable costs. The approach to lowering variable costs will vary by company and industry, but there are some general guidelines for reducing these expenses.
Making production more efficient is another way to reduce variable costs. This can be achieved by properly training employees or cross-training for multiple jobs and using well-maintained equipment.
Managing fixed and variable costs requires some level of expense tracking. This can be done by using software applications or manually maintaining a detailed spreadsheet. Alternatively, outsourcing Fractional accounting or Fractional finance consulting services can help keep fixed and variable expenses in check without increasing overhead costs.
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