Fixed And Variable Cost

When you start a business, you have two types of expenses to consider: fixed costs and variable costs. Fixed costs are expenses which do not change with sales activity. Variable costs, on the other hand, include all expenses which vary with the amount of product units you sell in a given period. Knowing which business expense falls under which category is important, for it helps to analyze a business’s profit behavior and enables you to strategize accordingly to improve your bottom line.

Let’s look into the details of the two business costs to better understand the concept of each.

Suppose you run an auto repair business. You have a small shop, few staff, some equipment and tools and an inventory of spare parts to service the cars that come to your shop for repair. Your business’s running expenses would include the rent of the shop, equipment depreciation expenses, cost of inventory, staff salary, insurance premiums, utility bills and advertising expenses. Of course, this list of expenses is not exhaustive, you can always add to it like medical billing services expense. But for now, let’s keep things simple and stick to the expenses listed above. We don’t want this session to become too overwhelming for you; our objective here is to help you get grips with accounting basics.

So which of the above expenses do you think should be placed under fixed costs and which should be included as variable costs? Take your time. Refer to the definition of the two we discussed earlier, and then come up with a list. Are you ready to tally your list with ours? Here you go…

Fixed costs incurred by your auto repair shop:

• Shop rent– this is not going to change, no matter how many cars your service in a day, week or month.
• Insurance premiums– you pay a fixed annual premium, it does not change with activity volume.
• Utility bills– electricity and gas costs to cool, heat and light the premises do not depend on how many cars you service each day.
• Advertising expenses– again, they remain fixed!

Variable costs incurred in running your auto repair shop:

• Cost of inventory– more cars you service, more spare parts you need.

You might wonder why staff salary and depreciation expenses have not been included in any of these lists? The reason? Their status is somewhat disputed.

Allow us to explain.

You pay your staff fixed wages. Whether they repair one car in a day or twenty cars, you pay them the wages you have agreed with them. But what about the overtime? Surely, there are going to be days when you will keep your shop open longer than the normal operation hours. This usually happens when you have too many jobs to complete in a day. The overtime will vary with the number of cars serviced.

So how do you solve this problem?

You can employ two strategies.

You can either divide your staff salary into the two components and list them separately under their respective categories. Or, you can calculate the average overtime you pay to your staff and treat it as a fixed cost. As for the depreciation expense, some business consulting services owners choose to treat it as a fixed cost, while others reference it as a variable cost. Normally, depreciation expense is calculated as a fixed cost for it makes the calculation easy to perform. Usage-based depreciation can be difficult to calculate but provides more accurate figures. Separating your business’s variable costs from fixed costs allows you to calculate the cost of goods sold/cost of units serviced, and you can take steps accordingly to make your operations more cost effective.

For instance, if your cost of goods sold is too high and its affecting your bottom line, you can strategize ways to reduce your overtime, or you may look into resourcing your inventory from other supplier who can sell you the spare parts on cheap. Similarly, if you believe you are paying too much in rent and you would be better off moving to another location, you can take that decision based on the assessment of your shop’s fixed expenses.

Was the post helpful? Let us know in the comments section below, we would love to hear from you. If you need any help with your accounting processes, we can also assist you in that. Our team provides professional accounting services and bookkeeping services to all types of small and medium sized businesses in South Florida. Contact us for a free initial consultation.

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