Fixed versus Variable Costs

When it comes to analyzing the business model of a operating business, one of the important items to focus on is the expenses.  One way that people often quote the expenses of their business is as two types: Fixed and Variable.

Fixed vs. Variable Costs

Fixed expenses are those recurring expenses that do not vary on a frequent basis, or are indexed and have predictable amounts.  Lease is a primary fixed expense, and is commonly indexed with periodic increases such as annual 2% increases.  Other fixed expenses are Equipment Leases, Finance Payments, Insurance.

Variable expenses are those that vary with the sales of the business.  Examples of these are Cost of Goods, Production Payroll, Utility Consumption, Delivery Expense.

Let’s start with the lease, which is another topic we have covered extensively.  Obviously, we have discussed how important it is to have the occupancy cost for any business be reasonable.  There are anecdotal metrics for each industry type, for example in the QSR field, the preferred amount is less than 10% of the gross sales.  If your lease payments are too high of a percentage of gross sales, you are working for your landlord.  Three ways out of this are to renegotiate your lease rate down, move to lower cost location, or increase your gross sales.  Of these three, we can assist with all of them.   Successful lease renegotiation must involve a willing landlord, relocating the business involves making sure that the new location works as well or better, and finally, increasing the gross sales must be done while maintaining the profit margins.  If you artificially increase the Gross Sales by slashing margins, you may not be adding to the bottom line enough to justify the extra work and toll on your employees and yourself.

Equipment leases are another source of fixed payments, that usually don’t vary by usage.  Just like the lease for the business, it is important to negotiate terms of equipment leases to make sure that you are getting a good deal and payment amounts that you ca live with further on down the road.

Finance payments go along with equipment leases in that they are important to negotiate at the outset, so you don’t tie yourself into untenable payment amounts.

Insurance Expenses can be fixed and variable.  Worker’s compensation insurance definitely varies based on the payroll, while liability insurance is typically fixed.  Same piece of advice goes here, negotiate and shop for good deals and good coverage.

Variable expenses start with the Cost of Goods.  Any inventory based business knows that it takes allocatable inventory to make a sale, and typically, the greater the sales, the greater the COG.  One benefit to higher sales is though, that there can economies of scale to leverage which would reduce the over COG per unit sold.  So there is something to be said for increasing volume at the expense of margin, just as long it is within reason, where reasonableness is defined by a sufficient profit margin.

Payroll is another variable expense that has it’s challenges in managing.  If revenues grow, do you add more staff, or do you extend your current staff to cover the additional business coming in.  Will productivity start decline as more is asked of the current employees, if so, the costs can be unsatisfied customers and costly order errors.  Also, overtime can be expensive, so it may cost less in hard dollars to add more staff, but there may be operational costs in downtime in training which redirects management’s attention to the rest of the business.

Delivery expense which is associated with the location of your business is also a key metric that you can tweak to wring savings and improved efficiency.  Think outside the box when it comes to reviewing the delivery philosophy of your business, we’ve seen quite a few business owners who have worn themselves ragged managing barely profitable delivery business.  Factor in gas, repairs, insurance, and accidents, and often time deliveries only make sense for High Margin routes.

For More information on how Just Elementary, Inc, Commercial brokers can help you with small business needs call (323) 213-9193 or email cs@justelementary.com