When you start a small business, you will have two types of expenses. Fixed expenses do not change with sales volume. Variable costs, however, do change with the volume of the product you sell. It is important to understand the relationship between your fixed and variable expenses, your sales volume, and your expected net profit. First, you have to understand your costs or expenses.
Fixed costs are the costs associated with the product that have to be paid regardless of the volume you sell. No matter how much you sell or don't sell, you have to pay your fixed costs.
An example of a fixed cost is overhead. Overhead may include rent for the space your company occupies such as your office space. It may also include your weekly payroll. Another fixed expense may be the depreciation you incur on your equipment. Those are just a few examples of expenses you have to pay no matter what your sales volume is.
Variable costs are directly related to sales. In fact, variable costs change with sales. As sales go up, so do variable costs. As sales go down, variable costs go down. Variable costs are costs of labor or materials that change with sales. One way for a company to save money is to reduce its variable costs. Sometimes, calculating variable costs is as simple as looking at your costs of goods sold on your income statement.
Examples of variable costs are the raw materials that go into creating the company's product and the labor the company uses. Other examples are costs of goods sold, sales commissions, delivery charges, shipping charges, wages and numbers of temporary or part-time employees, and bonuses to employees. If sales decline, all of these variable costs can decline and probably will decline.
Some costs have components that are fixed and some that are variable. One example is wages for your sales force. A portion of the wage for a salesperson may be a fixed salary and the rest may be sales commission. When calculating your fixed and variable costs, you should allocate the fixed portion to fixed costs and the variable portion to variable costs.
Costs, Sales Volume, and Profit
A change in any of your costs can drastically affect your net profit. A change in sales volume can also affect your net profit. Another variable that is important is the price of your product which interacts with volume and costs. Breakeven analysis shows the relationship between the price of the product you sell, the volume of the product you sell, and your costs or expenses. One of the variables you use in breakeven analysis, price, can be determined by further dividing up fixed and variable costs in direct and indirect costs