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.

To Budget or Not To Budget: That is the Question

A question came up today on one of my discussion groups—do most small businesses have a budget? I had to reply that most of my clients don't, but I think it’s a great idea!

There is a saying that “if you don’t know where you’re going, you’ll never get there”. If you haven’t spelled out your business’ financial goals, and how you are going to achieve them, how do you plan to have your business become a success? How will you even know if it HAS become a success?

Even for an accounting type like me, budgeting is about as much fun as a root canal. (Unless, of course, you’re Richard Branson--I’d like to have his budgeting woes for a change!) But researching costs and pricing strategies, getting those numbers down on paper and doing the math can be an eye-opening experience. It can head you off from disaster as well as highlight opportunities for improvement. Doing a monthly check to see how you’re doing compared to the budget can keep you on track to meet your financial goals and let you know if you need to make a course correction.  A budget can also be used for scenario planning—seeing what effect a change in your operations or your pricing will have on the bottom line

How do you get started on preparing a budget? If you’ve been in business for a while, you can use your actual results as a starting point. QuickBooks, for example, will let you create a budget based on your prior year’s results, and then you can modify it for anything that you know will be different. This is the easiest way to create a budget, but it has some drawbacks. You may have some inefficiencies that won’t be identified this way, they will just roll forward. The process doesn’t force you to really look at the underlying activity behind the line item amounts.

If you’re just starting your business, or if you want to take an in-depth look at your finances, you will probably create a budget from scratch. You will project your income, your cost of sales, and your expenses in detail to create your budget. This is more time-consuming but forces you to really take a look at how they money is coming in and going out.

Preparing a budget for your income statement is the most common form of budget. In addition, it’s a good idea to prepare a capital budget to plan for purchases of equipment, and a cash flow projection to tie it all together.

While very few people will consider budgeting to be the most fun part of running their business, it can be one of the most instrumental tools for achieving financial stability and success.

If you’re a small business owner, please leave your comments on what type of budget process you use to project your financial results.