FixedandVariableCosts:EssentialBuildingBlocksSmallbusiness

ownersdividetheircostsintotwocategories.Variablecostschangebasedonthe volumeofunitssold.Fixedcostsmustbepaidregardlessofwhetherornotsalesare beinggenerated. Variablecostschangewithsales.Theyfallintotwosubcategories: 1.Costofgoodssold(COGS),orcostofservicessold(COSS),whichisassociated specificallywitheachunitofsale,including:Thecostofmaterialsusedtomakethe product(ordelivertheservice)Thecostoflaborusedtomaketheproduct(or delivertheservice) 2.Othervariablecostsinclude:Commissionsorothercompensationbasedon salesvolumeShippingandhandlingcharges Fixedcostsstayconstantwhetheryousellmanyunitsorveryfew. Examplesoffixedcostsincluderent,salaries,insurance,equipment,and manufacturingplants.HenryFordspentmoneyonefficientmanufacturing equipment(afixedcost)butsavedafortuneonlabor(COGS)bydoingso.This reducedhistotalcostsbecauselaborwasusedineachofthemillionsofcarsFord produced,butheonlyhadtopayfortheplantandequipmentonce.Foranyunitof sale,youcanstudyitsEconomicsofOneUnittofigureoutwhatitcosttomakethat sale.Figure72showsanexamplefromabusinessthatsellshandpaintedvintage Tshirts.

CalculatingEOUWhenYouSellMoreThanOneProductMostbusinessessellmore thanasingleproductandtheyalsocanuseEOUasavaluemeasureofproduct profitability.AbusinesssellingavarietyofproductshastocreateaseparateEOUfor eachproducttodeterminewhethereachoneisprofitable.Whentherearemany similarproductswithcomparablepriceandcoststructures,atypicalEOUcanbe used.Example: Jamaalsellsfourkindsofcandybarsatschool.Hesellseachbarfor$1,but hepaysadifferentwholesalepriceforeach: Snickers36each AlmondJoy38each Butterfinger42each BabyRuth44each RatherthanmakeseparateEOUs,Jamaalusestheaveragecostofhisfourcandy bars(seeFigure73).Costsofthefourcandybars(36384244)4Average costofthefourcandybars$1.604Averagecostofeachbar40Usinganaverage worksifthecostsareclose,andaslongasJamaalsellsroughlythesamenumberof eachbrandofbar.IfhecannolongergetSnickersandAlmondJoyatsomepoint,for example,heshouldthenchangehisEOUtoreflectthehigherpriceoftheothertwo bars.

Whatifeachunitofsaleismadeupofacomplexmixofmaterialsandlabor?The EOUcanstillhelpyoufiguretheCOGS,othervariablecosts,andgrossprofitforthe product,althoughtheprocesswillbemorecomplex.

Example:DenisesellsturkeysandwichesfromherdelicartdowntownonSaturdays. Shesellseachfor$5.Thematerialsandlaborthatgodirectlyintomakingeach sandwicharetheCOGS.Thecostsofthematerialsanddirectlaborforproduction arecalledinventorycostsuntiltheproductissold.Therewillalsobesomeother variablecosts,suchasnapkins,apaperwrappingforeachsandwich,andplastic bags.First,makealistoftheCOGS,andanyothervariablecosts:COGSa.Turkey costs$2.60perlb.Eachsandwichuses4oz.ofturkeymeat(16oz./1lb.).b.Bread (largerolls)cost$1.92perdozen.Onerollisusedpersandwich.c.Oneounceof mayonnaiseisusedpersandwich.A32ouncejarofmayocosts$1.60.d.Lettuce costs80centsperlb.and1/16ofapound(1ounce)isusedoneachsandwich.e. Tomatoescost$1.16each.Eachsandwichusesafourthofatomato.f.Each sandwichcomeswithtwopickles.Picklescost5centseach.g.Employeesarepaid$ 7perhourandcanmake10sandwichesperhour(weareassumingnodowntime andnopayrollcosts).

OtherVariableCostsThefollowingsuppliesareusedeverytimeasandwichissold, butarenotstrictlypartofthesandwichsproduction:a.Napkinscost$3perpackof 100.Onenapkinisincludedwitheachsale.b.Paperwrappingcosts20centsper foot(onaroll).Eachsandwichusestwofeetofpaper.c.Plasticcarryoutbagscost$ 7perrollof100.Eachsandwichsoldusesoneplasticcarryoutbag.(Inreality,more thanonesandwichmightgointoabag.)TheEOUfortheturkeysandwichisshown inFigure74.

FixedOperatingCosts

Costs,suchasrentortheInternetbill,whichdonotvaryperunitofproductionor service,arecalledfixedoperatingcosts.Fixedoperatingcostsarenotincludedin COGS(orCOSS)becausetheyarenotdirectcostsofcreatingeachproduct(or service). 1Fixedoperatingcostsarenotincludedinothervariablecostsbecausetheydonot varydirectlywiththenumberofsalesmade.Fixedoperatingcostsdonotchange basedonsales;therefore,theyarenotincludedintheEOU.Asandwichshophasto paythesamerenteachmonthwhetheritsellsoneturkeysandwichorahundred. However,theowneroftheshopcanchangethecostoftherentbymoving,orcanin creaseordecreasetheadvertisingbudget,andthelike.Thesechangesarenot calculatedonaperunitbasis. Aneasywaytorememberthesevencommonfixedoperatingcostsiswiththe acronymUSAIIRD: Utilities(gas,electric,telephone,Internetservice) Salaries(indirectlabor) Advertising Insurance Interest Rent Depreciation Mostofthesecategoriesareselfexplanatory,butdepreciationmayneed clarification. Depreciationisthepercentageofvalueofanassetsubtractedeachyearuntilthe valuebecomeszero,toreflectwearandtearontheasset.Itisamethodusedto expense(listedasanexpenseontheincomestatement)costlypiecesofequipment. Fixedcostsareexpensedduringtheyearthemoneyisspent.Whenacompany paysforadvertising,itsubtractsthatcostfromthegrossprofitforthatyear.Some items,however,suchasacomputer,areexpectedtolastforanumberofyears.A businesscouldchoosetoexpenseacomputerduringtheyearitwasbought,butthat wouldnotbeaccurate.Acomputerthatwillbeusedfor4yearswillhavebeenonly 25percentusedupduringtheyearitwaspurchased.Expensingtheentirecostof thecomputerduringthatyearmakestheaccountingrecordsandfinancial statementsinaccurate.Ifmorethan25percentofthecomputerscostisexpensedin thefirstyear,theincomestatementwillshowalowerprofitthanitshould. Meanwhile,profitsinsubsequentyearswillappeartobehigherthantheyshould. Thisproblemisaddressedbydepreciation,whichspreadsthecostofanitem purchasedbyabusinessovertheperiodoftimeduringwhichitwillactuallybein use.Ifthecomputerwillnotbereplacedfor4years,thenthefullpriceshouldbe shownasanassetandthenexpensed25percenteachyear.Inthisway,thecostof

thecomputeranditsvaluetothecompanywillbereflectedmoreaccurately.Fixed OperatingCostsDoChangeOverTime Ifyoupayyourrestaurantmanager$3,600permonthinsalary,youwillhaveto paythatamountwhethertherestaurantsellsonemealorathousand.Thecostis fixed.Fixedoperatingcostsdochangeovertimeatsomepointyoumaygiveyour restaurantmanageraraise.Or,youmighthireanewmanageratalowersalary.The wordfixeddoesnotmeanthecostneverchanges,justthatitdoesnotchangein responsetounitsofproductionorsales. Forinstance: Advertising:Thecostofadvertisingwillchangebasedondecisionsthe entrepreneurmakesabouthowmuchtospendtoreachtheconsumer,notbecause ofcurrentsales. HeatingandCoolingCosts:Thepriceofheatingandcoolinggoesupordownbased ontheweatherandutilityprices,notontheamountofrevenuethebusinessearns.

AllocateYourFixedOperatingCostsWherePossible
Businessownersliketoknow,whenevertheymakeasale,howmuchofthat revenuewillhavetobeusedtocovercostofgoodssoldandothervariablecosts. WhateverisleftoverafteryoupaytheCOGSandothervariablecostsisyour contributionmargin(grossprofit).Youwillpayyourfixedoperatingcostsoutof yourcontributionmargin.Whateverisleftoverafteryoupayyourfixedoperating costs(andtaxes)isyournetprofit.Fixedoperatingcostscanbedangerousbecause theyhavetobepaidwhetherornotthebusinessmakesagrossprofit.The entrepreneurshouldbecarefulabouttakingonfixedcosts,butdoesnothaveto worrysomuchaboutvariablecostsbecause,ifsalesarelow,variablecostswillbe lowaswell.Whereverpossible,theentrepreneurshouldseektoallocateor distributeasmanycostsaspossiblebymakingthemvariable. Hereisanexampleofhowtofullyallocateyourcosts,sothatyouknow,eachtime yousellaunit,howmuchofyourfixedandvariablecoststhesalecovers.Example: Ifyousell300watchespermonthat$15perwatch(seeFigure75),yourCOGSis$ 2perwatchandyourothervariablecostsarecommissionsof$2perwatchand shippingchargesof$1perwatch.Grossprofitperunitis$13($3,900ingross profitdividedby300watchessold).Contributionmarginperunitis$10($3,000 300).Someofthisgrossprofitwillhavetobeusedtocoverthebusinesssfixed operatingcosts.Itishelpfultodeterminehowmuchprofitwillbeleftoverafter payingthefixedoperatingcosts,assumingyoursalesarestable.Figure76shows thecalculationofthetotalcostperunit.Foreverywatchyousell,yourtotalcost, fixedandvariable,is$6.50.Ifyoureceive$15foreachwatch,therefore,yourprofit beforetaxisthefollowing:$15.00sellingprice$6.50totalcostperunit$8.50 profitbeforetax.

TheDangersofFixedCosts

Ifabusinessdoesnothaveenoughsalestocoveritsfixedcosts,itwilllosemoney.If lossescontinue,thebusinesswillhavetoclose.Aswehavediscussed,fixedcostsare dangeroustoabusinessbecausetheymustbepaidwhetherornotthebusinessis makingenoughsalestocoverthem.Variablecosts,ontheotherhand,donot threatenabusinessssurvivalbecausetheyareproportionaltosales.

HowInflationCanHurtSmallBusinessOwners

Inflationisthegradual,continuousincreaseinthepricesofproductsandservices, usuallyresultingfromanincreaseintheamountofmoneyincirculationinan economy.Itcanbetheenemyofthesmallbusinessowner.Ifyousave$600per yeartobuynewtablesandchairs(whichcost$3,000)foryourrestaurant,butfind attheendof5yearsthatthecostofreplacingthemhasrisenduetoinflationto $5,000,yourbusinesscouldbeintroubleifyoucannotgettheadditional$2,000. Savvyentrepreneurskeepupwitheconomictrendsbyreadingthefinancialsection inthenewspapers,aswellasfinancialmagazinesandWebsites.Bystayingupto dateonwhatishappening,entrepreneurscanplanbetterforthefutureandinvest wisely. UsingAccountingRecordstoTrackFixedandVariableCosts Nowyouarereadytosetupyourfinancialrecords.Nothingthatyoulearnasan entrepreneurwillbemoreimportantthankeepingaccuraterecordsofthemoney flowinginandoutofyourbusiness.Thesystematicrecording,reporting,and analysisofthefinancialtransactionsofabusiness(keepingnumericalrecordsof inflowsandoutflows)iscalledaccounting.Itistheprimarylanguage businesspeopleusetocommunicate.Whenyoutalktoaninvestororasupplier aboutyourbusiness,youwillneedtousethislanguage.Heorshewillwanttosee financialstatementsforyourbusinessthatdescribeitsperformanceataglance. Beforeyoucancreatefinancialstatements,however,youmustbeabletokeeptrack ofyourdailybusinesstransactions.Ifyoudeveloprecordkeepingintoahabit,you willbewellaheadofthemanybusinesspeoplewhotendtosticktheirheadsinthe sandwhenitcomestokeepinggoodrecordsconsistently. ThreeReasonstoKeepGoodRecordsEveryDay 1.Keepinggoodrecordswillshowyouhowtomakeyourbusinessmoreprofitable: Perhapsyouaremakinglessprofitthismonththanlast.Didyourexpensesgoup? Maybeyouneedtotryloweringyourcosts.Didyoursalesdrop?Maybeyouarenot spendingenoughonadvertising.Useaccuraterecordstoconstantlyimproveyour business. 2.Keepinggoodrecordswilldocumentyourbusinessprofitability:Ifyouwant peopletoinvestinyourbusiness,showthemthatitisprofitable.Keepaccurate recordstocreatefinancialstatementsandratiosthatproveyourbusinessisdoing well.Remember,youwillalwaysneedtomaintainyourfinancialstatementssothat youwillbeuptodateonyourbusinessperformance. 3.Keepinggoodrecordsprovesthatpaymentshavebeenmade:Accurate,uptodate recordshelppreventargumentsbecausetheyproveyouhavepaidabillorthata customerhaspaidyou.Recordsalsoprovethatyouhavepaidyourtaxes,thefee charged(levied)byagovernmentonanincome,product,oractivitythatisimposed onanindividualorlegalentity(corporation).SometimestheInternalRevenue

Service,thefederalagencythatcollectstaxes,willvisitabusinessandcheckits financialrecordsinaprocesscalledanaudit.Ifyoukeepgoodrecordsandpayyour taxesinatimelyfashion,youwillhavenothingtofearfromaudits. ExcerptedfromEntrepreneurship:StartingandOperatingaSmallBusinessSecond EditionBySteveMariotti;CarolineGlackin