In business terms, what is fixed cost, and how do you know if it is feasible for your business? Basically, in economics and accounting, fixed costs are non-reusable costs or overhead expenses which are not dependent upon the actual level of production or goods produced by the company. They tend to be recurrent, like annual maintenance fees or interest being paid. These costs should not change due to factors outside of the control of the company.
With a fixed cost, however, the cost cannot be changed without significant penalty or increased cost. It is a catch-22 situation. It is very difficult, if not impossible to determine what the fixed costs will be in the future because they cannot be predicted. If the price of a product increases substantially, there will undoubtedly be increased variable costs. But if the price stays the same, there will be no increase in variable costs and no increase in actual costs. That is a very tough situation.
With that said, it is extremely difficult for a small business owner to make the determination of what is variable and what is fixed based on a particular line item in the financial statement. This can make accounting challenges for a small business owner. The best way to overcome this issue is to develop a spreadsheet that will help the small business owner identify both variable and fixed expenses. Once this has been established, the small business owner can determine what is variable and what is fixed based on actual costs over a given time frame.
Why is it so challenging to make this determination? There are many reasons. One major reason is that most variables tend to change directly with the economy. Another reason is that many companies try to control for variable costs by passing the cost of one variable onto another. That means the actual costs will vary from year to year and from quarter to quarter. The end result is that the true variable cost is often not determined directly by the company, but instead is estimates by management.
If management is able to successfully manage the variables that they pass onto you, there is an excellent chance that you will never have to worry about “what is variable and what is fixed”. On the other hand, if you are not able to do that, you run the risk of your accounting information being misinterpreted or even totally misconstrued. This could result in you paying much more than you need to for certain assets because of incorrect accounting information. It could result in the loss of a large customer, which could result in your small business becoming bankrupt. In short, incorrect accounting could have a devastating effect on your business.
So how do you know what is fixed and what is variable? There is really only one way to truly determine what your fixed costs are. That is to calculate them using your last year profit and determine what it would take to run the operations of your business without any variable costs. You could then divide that number by your revenue to arrive at a fixed cost. This will help you see where most of your fixed expenses are, which is very helpful in planning for future year’s financial results.
The only exception to this rule is when a business activity or service has a direct benefit that can be impacted by changing conditions. Let’s say that you produce musical instruments, and the quality of their sound is in decline. In this case, the price you pay for the instruments will change directly as a result of their decline in value. However, since you purchased them at their current price, you know that you will be able to charge them more in the future, assuming their quality remains the same. If you were to change the music industry regulations, you could sell your instruments at a higher price and realize a significant profit difference over the next few years. While there is a chance that the prices you charge now will increase, chances are that this won’t happen in the very near future.
The bottom line is that if you want to determine whether your business activity is increasing or decreasing, you need to determine whether or not it is based on a fixed or variable cost analysis. As a small business owner, your fixed costs are likely your most valuable assets, because they provide a direct benefit that directly impacts your bottom line. Unfortunately, small business owners often don’t recognize these benefits, and as a result they spend unnecessarily to keep up with the Joneses. However, by understanding the difference between cost and revenue, you will be better prepared to successfully navigate this extremely competitive business environment. So, while variable costs may appear as a good thing at times, they can often become a problem if you allow them to control your operating costs.