How Do Expenses Impact Profitability?Resources For Small Businesses: Profit Spear Consulting LLC

How Do Expenses Impact Profitability? What Are Fixed And Variable Costs?

Every successful and profitable business knows how to manage its expenses efficiently. To survive and thrive in very competitive environments businesses must focus on being cost sensitive and develop a culture of continuous cost reduction. Costs or expenses incurred in running a business can be broadly classified into two main categories: Variable and Fixed.

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Variable and Fixed Costs

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Variable and Fixed

By knowing what costs are variable versus fixed, a business owner can identify the impact it will have on profitability and make smart changes to the business and stay profitable even in difficult times. Variable cost, as the name suggests, varies up and down with sales/revenue, while fixed cost does not.

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Fixed Costs

Some examples of fixed costs are, real estate and rent, overhead such as insurance, payroll and benefits, most utility costs, building and equipment maintenance, loan/debt payments and such. Every business will incur fixed costs to run its operations, and because the ups and downs in sales and revenues have no impact, it would make most sense to keep it as low as possible to protect profitability especially when sales are down. Businesses with high fixed costs must generate sufficiently enough sales and revenues to drive healthy profit margins, if not, high fixed costs could become a drag on profitability.

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Variable Costs

On the other hand, some examples of variable costs are, cost of goods sold, raw materials, shipping, fuel, product manufacturing costs, and such. As business produces more or has increasing sales, the cost associated with that also increases, as more material and labor is needed to produce more goods and services. Although every business wants to keep growing sales, there are times when sales could be down due to various reasons. Since variable costs are tied to sales, when sales are down, so are costs. If a business model has operating expenses that are high in variable costs, it most likely will have thinner margins (revenue minus cost of goods and services), and any increase in variable cost can have significant impact on profits.

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What would be a good and healthy cost structure?

Lowering both fixed and variable costs will obviously improve profitability. But depending on the nature of your business, it’s prudent to figure out what costs are more impactful and focus on driving those lower. It sometimes could be a mix of both variable and fixed with one more weighted that the other.

If your business model is based on selling goods and products then most likely this would mean that the variable costs such as cost of goods, raw material, labor, and such, are a significant part of the overall operating expenses, and should kept as low as possible. Every penny saved on each dollar of sales goes straight to the bottom line as profit. On the flipside, if fixed costs are high and are a bigger portion of the overall operating expenses, then you must generate appropriately high enough volume of sales and revenues to make sure you not only cover all fixed costs, but also variable costs associated with sales, and then some, to make sure you have a healthy profit margin. It’s obvious that both variable and fixed costs should be as low as possible to increase profit margins, but if you have to it play safe during tough times, then keeping fixed costs low could be the right choice if there is risk and uncertainty around sales and revenues.