subject: Difference Between Fixed And Variable Costs [print this page] An important factor in operating any business successfully is understanding cost behavior and how it affects profitability. As the current economy offers challenges in operating efficiently, many owners find themselves working harder than ever to keep up. Knowing the difference between fixed versus variable costs is beneficial for predicting sales as other factors change.
Variable Costs
Variable costs are expenses that change based on the activity level of the business. For example, a company producing aquariums purchases their base materials from an outside source. These materials are then assembled into a product at their warehouse.
Assume that the direct cost of materials for each unit is $10, and the company manufactures anywhere between 5,000 and 30,000 aquariums each quarter. Even though the cost of materials for each unit remains unchanged, the actual material expense will fluctuate based on product production. As the demand for aquariums rises and falls, so does the amount of money needed for purchasing materials.
Fixed Cost
Fixed costs are expenses that remain unchanged even when the activity of a business varies. Probably the most common example of this is the cost of rent. Regardless of production or sales, the monthly amount remains the same.
Another illustration that demonstrates this is salary. If a company selling perfume pays the production manager a salary of $54,000 per year, this expense remains the same. The tricky part is that even though this particular cost is fixed, it still affects the overall cost of each bottle.
Cost Behavior and Profitability
In tracking the associated costs, a business is able to analyze ways to improve overall revenue. This is sometimes referred to as a cost-volume-profit ratio. One vital factor in this is the contribution margin.
This tells the business owner how much profit is left over once a product or service is sold. Increasing profitability usually means increasing the contribution margin by reducing certain expenses.
Due to the complicated relationship between fixed and variable costs, small business software can be beneficial. While the expenses can be divided into specific categories, the impact of cost on revenue can be more difficult to establish. Accountants use mathematical equations to provide this information. Small business software puts this information at the fingertips of the owner.
One of the largest expenses that a business can realize is that of payroll. This cost can be variable or fixed depending on the industry. Sometimes, as the activity of a business increases, so do the staffing needs.
Again, the overall expense affects the contribution margin. The cost analysis should breakdown the amount spent by department. Furthermore, it is also necessary to track department productivity. Payroll software is a critical step in identifying where the money is allocated and how to reduce expense without damaging quality.
