The costs incurred by most businesses can generally be placed into one of two categories being either fixed costs or variable costs. A key to ensuring success in any business is to firstly understand the different categories costs fall into and then working to find the balance between these costs with a focus on obtaining a clear understanding of the business’ overall profit margin and break even point.
Below is a brief summary of these key financial measures to help you quantify them in relation to your business operations.
When it comes to identifying fixed costs what you need to consider is that if the expense will still be incurred at the same time for the same amount regardless of the level of sales income generated then it is a fixed cost. These costs can have a considerable impact on the profitability of a business, not to mention cash flow if not managed effectively.
In summary, fixed costs:
- Do not change with sales volume, but remain consistent regardless of the level of sales
- Are commonly refered to as overheads
- Examples include rent, insurance, utilities, property taxes and interest expenses
Variable costs are classified as those ‘direct’ costs required to produce your product or service. With these types of costs as your sales volume increases so do the variable costs and as sales volume decrease, variable costs will reduce also.
In summary, variable costs:
- Increase or decrease in line with the sales volume of a business.
- Are commonly refered to as Direct Costs
- Typical types of variable costs include purchase of materials to produce a product, food supplies for a café, commissions, merchant/credit card fees and freight costs
It can get tricky categorising expenses between these two types as some costs can have both fixed and variable elements. Wages for example can have a fixed and variable element depending on staffing requirements for regular versus busy seasons.
Finding the balance between fixed and variable costs and understanding how they interact is the key to managing profitability and operating a successful business. In understanding how these costs interact with your activities you will be in a position to calculate your business’ gross profit margin and break-even point.
Gross Profit Margin
The profit margin of a business quantifies the amount of profit made on a product in relation to the variable costs incurred in producing it. In simple terms, it is the money left over from sales after deducting the costs of goods sold to create the sale.
Knowing your profit margin and monitoring it can help you track profitability trends, measure your profitability against industry and competitor benchmarks and help you to forecast and manage your cashflow requirements. It can also help you to ensure you capture and on-charge or plan for any cost increases as a reduction in your gross profit margin can indicate an increase in the costs you are incurring to genrate the sales.
The break-even point of a business relates to the level of sales requried to cover all business expenses including both fixed and variable costs. We have noted above that fixed costs are incurred regardless of the volume of sales, whereas variable costs will fluctuate in line with sales volume.
As such, if the fixed costs are unavoidable, what level of sales does a business need to generate to cover not only the variable costs but the fixed costs as well? This is the basis of the break-even point and an understanding of where your break-even point is, is the key to business sustainability and driving profitabilty.
Recognising the relationship between fixed and variable costs is important for any business in determining sales prices and managing business expenses. Determining the break-even point is the key to quantifying what level of activity you need to generate to cover your costs and more importantly, what you need to do over and above this to turn your business into a profitable one.
For more information on how to assess these metrics for your business please contact us at firstname.lastname@example.org or on 03 5221 6399.
Disclaimer: this information is of a general nature and should not be viewed as representing financial advice. Users of this information are encouraged to seek further advice if they are unclear as to the meaning of anything contained in this article. Davidsons accepts no responsibility for any loss suffered as a result of any party using or relying on this article.