Am I Going to Make Money on This? Understanding Fixed and Variable Costs

I recently sat in on a webinar hosted by a business coach. The topic was taking steps to pursue your dream of starting your business, and the subject of money came up, as it usually does! The point was to run the numbers to make sure your idea will actually work, a refreshing change to "Do what you love, the money will follow." Actually, often if you do what you love, the money WILL follow, but not if you aren't smart about it. The coach mentioned reviewing your fixed and variable costs, and then moved on.

Fixed and variable costs are a bit of a mystery to many small business owners. In reality, it's pretty basic concept. Fixed costs are the ones that are not likely to change, or won't change much, no matter how much business goes up or down. Rent is an example of a fixed cost, as are most salaries. Variable costs are the ones that go up or down in relation to how much business you do. If you are manufacturing a product, variable costs include the cost of materials and hourly labor.

Some of the confusion is because people often think of costs in terms of a percentage of sales. If your rent is $500 per month, and you are making a product that you sell for $100 and your materials and labor are $50 per unit, then your material and labor are always going to be 50% of sales--but the total amount you will spend per month on them will vary as your sales volume changes. But rent will always be $500, even though rent as a percent of sales will change with volume.

In truth, many items are not strictly fixed or variable. You may have a commitment to your production staff to pay them for a certain number of hours regardless of how many units are produced. If your operations grow, you may need to rent more space. Utilities are often a blend, with a base amount that you will spend no matter what your production volume is, but as production and sales grow, they may grow as well.

Why is this important? When crunching the numbers to see if you will be making a profit, you need to understand what costs are fixed and what are variable.The first thing you should do is see what volume of sales you need to make to break even. This is called "break-even analysis".

Very loosely speaking, your gross margin is likely to be the difference between your sales dollars and the variable costs associated with those sales. To break even, you need to sell enough units so that margin covers your fixed costs. Your scenario planning should look at results based on various levels of sales to see how much profit you can make at different levels of sales, or give you a heads-up about when you will not be breaking even.

Doing this planning may not be the most fun or glamorous part of starting your business, but it can be the difference between making it big and not making it at all! It will at least give you an eye-opening look at your plan and let you make adjustments so you can, in fact, do what you love and have a good chance that the money will indeed follow.