What Does This Do to the Bottom Line... ?
By Mark Munday
This question keeps on popping up and complicating business decisions. Not being able to answer it leads to bad business decisions being made. And it is a major cause of small businesses going bust.
For example, do you know what will happen if your sales volume drops? How far can it drop before you really start to eat red ink? And if you lower your prices in order to sell more, how much more will you have to sell to make the same profit?
If you take out a loan, what sales volume will you need to cover those increased costs? And if you take on a new employee, how much more turnover is required to pay the extra salary?
To be able to answer these questions, you need to have a good understanding of what your fixed costs, variable costs and profit margins are. You also need a good understanding of the relationships between these variables.
Cost/volume/profit analysis helps you answer these, and many more, questions about your business operations. The most important concept is the distinction between fixed costs and variable costs and what this means to you.
Getting to grips with this distinction enables you to do quick "back-of-the-envelope" calculations of the financial impact your business decisions have. The rest of this article examines this distinction.
Types of costs:
Virtually all of your business' costs fall, more or less neatly, into one of two categories:
Variable costs, which increase directly in proportion to the level of sales. Some examples would be sales commissions, shipping charges, delivery charges, cost of direct materials or supplies, wages of temporary employees, and sales or production bonuses. They all increase as sales go up and decrease as sales come down. So they can be directly built into selling prices.
Fixed costs, which remain the same regardless of your level of sales. Typical examples are rent, interest on debt, insurance, plant and equipment expenses, business licenses, and salary of permanent staff. Because they are not directly linked to sales, fixed costs have to be recovered by spreading them across all sales transactions.
Deciding which costs are fixed and which are variable is not always easy. Some costs appear to be both fixed and variable.
Combination costs : a certain minimum level is incurred regardless of sales levels. But increases in sales volume also cause these costs to rise. Your phone bill is an example. You pay a line charge that is the same each month. And you also pay a charge based on the number of calls you make., which is usually linked to sales volumes.
Strictly speaking, these costs should be separated into their fixed and variable components, but that may be more trouble than it's worth for a small business. To simplify things, just decide which type (fixed or variable) best describes the cost and classify the whole item accordingly. For example, in a telemarketing business, phone call charges are normally far greater than line charges, so you'd classify the entire bill as variable.
Relevant range of activity: It's important to realize that fixed costs are "fixed" only within a certain range of activity. For example, your rent is a constant amount per month. But only until your sales increase to the point where you need to rent an additional workplace, in which case it might double.
In the long term, all costs become variable. But for the purpose of understanding your cost structure, costs that stay constant over a 12 month period are regarded as fixed.
Next month, we consider how to use your understanding of your business' fixed/variable cost structure to estimate the impact of business decisions on your bottom line. Pricing for Profit.
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As a Business Strategist and Coach, Mark works with business owners to help them achieve their business goals. His powerful strategic planning and implementation techniques produce stunning results for clients. Go to http://www.sBusinessPlanz.com/ for details.
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