The costs involved in running a business can be put into two groups: fixed costs and variable costs.
- Fixed costs are costs that do not change depending on how many sales you make. They are things like ‘overhead’ costs such as rent, insurance, power, internet, and wages. They also include non-cash expenses such as depreciation on assets the business has purchased.
- Variable costs change depending on how many sales you make. Variable costs could include the price at which products or raw materials are purchased from suppliers, the wages of production staff, and freight costs. For example, if a small business which produces skincare products receives a large order from a customer, its costs will increase as it will need to buy ingredients to make those products.
It can be difficult to decide if a cost is a fixed cost or variable cost due to the fact a cost does change, but not all the time, and usually only when sales increase by a large amount. The wages you pay staff may be an example of this. Some staff (such as the owner) may work in the business all the time and receive the same salary regardless of how much sales are made. However, if sales increase a lot, or you intend to grow the business, you may need to take on another employee.
As a general guide, it is best to count wages and salaries as fixed costs, unless they are directly related to changes in sales. For instance, if you only need to pay someone wages to do a task if you make a sale, count it as a variable cost. However, if that person will be paid regardless of how many sales are made (if any at all), count wages as a fixed cost.
Costs and Profit
Profit can be increased by lowering fixed costs and / or variable costs. For example, you could find cheaper premises to rent, or change electricity providers to lower your fixed costs. To lower your variable costs, you could find cheaper suppliers or try to use fewer raw materials for each product made.
However, when it comes to understanding profitability, there are two main points to keep in mind:
- You will need to cover your fixed costs, no matter how many sales you make. The lower your fixed costs, the less risky your business is. By keeping your fixed costs low, it is more likely you will make a profit, even in times when sales are low. This is why it is important you are aware of what your fixed costs are, and to look for ways to reduce them.
- Your variable costs have an impact on how much profit you make from each sale. You need to be clear about how much each sale is costing you, so you can make good decisions about pricing and discounts. Also, the higher your variable costs are, the less money there will be available to cover your fixed costs.