FixedandVariableCosts:EssentialBuildingBlocksSmallbusiness

ownersdividetheircostsintotwocategories.Variablecostschangebasedonthe
volumeofunitssold.Fixedcostsmustbepaidregardlessofwhetherornotsalesare
beinggenerated.

Variablecostschangewithsales.Theyfallintotwosubcategories:
1.Costofgoodssold(COGS),orcostofservicessold(COSS),whichisassociated
specificallywitheachunitofsale,including:Thecostofmaterialsusedtomakethe
product(ordelivertheservice)Thecostoflaborusedtomaketheproduct(or
delivertheservice)
2.Othervariablecostsinclude:Commissionsorothercompensationbasedon
salesvolumeShippingandhandlingcharges

Fixedcostsstayconstantwhetheryousellmanyunitsorveryfew.
Examplesoffixedcostsincluderent,salaries,insurance,equipment,and
manufacturingplants.HenryFordspentmoneyonefficientmanufacturing
equipment(afixedcost)butsavedafortuneonlabor(COGS)bydoingso.This
reducedhistotalcostsbecauselaborwasusedineachofthemillionsofcarsFord
produced,butheonlyhadtopayfortheplantandequipmentonce.Foranyunitof
sale,youcanstudyitsEconomicsofOneUnittofigureoutwhatitcosttomakethat
sale.Figure72showsanexamplefromabusinessthatsellshandpaintedvintage
Tshirts.

CalculatingEOUWhenYouSellMoreThanOneProductMostbusinessessellmore
thanasingleproductandtheyalsocanuseEOUasavaluemeasureofproduct
profitability.AbusinesssellingavarietyofproductshastocreateaseparateEOUfor
eachproducttodeterminewhethereachoneisprofitable.Whentherearemany
similarproductswithcomparablepriceandcoststructures,atypicalEOUcanbe
used.Example:
Jamaalsellsfourkindsofcandybarsatschool.Hesellseachbarfor$1,but
hepaysadifferentwholesalepriceforeach:
Snickers36each
AlmondJoy38each
Butterfinger42each
BabyRuth44each

RatherthanmakeseparateEOUs,Jamaalusestheaveragecostofhisfourcandy
bars(seeFigure73).Costsofthefourcandybars(36384244)4Average
costofthefourcandybars$1.604Averagecostofeachbar40Usinganaverage
worksifthecostsareclose,andaslongasJamaalsellsroughlythesamenumberof
eachbrandofbar.IfhecannolongergetSnickersandAlmondJoyatsomepoint,for
example,heshouldthenchangehisEOUtoreflectthehigherpriceoftheothertwo
bars.

Whatifeachunitofsaleismadeupofacomplexmixofmaterialsandlabor?The
EOUcanstillhelpyoufiguretheCOGS,othervariablecosts,andgrossprofitforthe
product,althoughtheprocesswillbemorecomplex.

Example:DenisesellsturkeysandwichesfromherdelicartdowntownonSaturdays.
Shesellseachfor$5.Thematerialsandlaborthatgodirectlyintomakingeach
sandwicharetheCOGS.Thecostsofthematerialsanddirectlaborforproduction
arecalledinventorycostsuntiltheproductissold.Therewillalsobesomeother
variablecosts,suchasnapkins,apaperwrappingforeachsandwich,andplastic
bags.First,makealistoftheCOGS,andanyothervariablecosts:COGSa.Turkey
costs$2.60perlb.Eachsandwichuses4oz.ofturkeymeat(16oz./1lb.).b.Bread
(largerolls)cost$1.92perdozen.Onerollisusedpersandwich.c.Oneounceof
mayonnaiseisusedpersandwich.A32ouncejarofmayocosts$1.60.d.Lettuce
costs80centsperlb.and1/16ofapound(1ounce)isusedoneachsandwich.e.
Tomatoescost$1.16each.Eachsandwichusesafourthofatomato.f.Each
sandwichcomeswithtwopickles.Picklescost5centseach.g.Employeesarepaid$
7perhourandcanmake10sandwichesperhour(weareassumingnodowntime
andnopayrollcosts).

OtherVariableCostsThefollowingsuppliesareusedeverytimeasandwichissold,
butarenotstrictlypartofthesandwichsproduction:a.Napkinscost$3perpackof
100.Onenapkinisincludedwitheachsale.b.Paperwrappingcosts20centsper
foot(onaroll).Eachsandwichusestwofeetofpaper.c.Plasticcarryoutbagscost$
7perrollof100.Eachsandwichsoldusesoneplasticcarryoutbag.(Inreality,more
thanonesandwichmightgointoabag.)TheEOUfortheturkeysandwichisshown
inFigure74.

FixedOperatingCosts

Costs,suchasrentortheInternetbill,whichdonotvaryperunitofproductionor
service,arecalledfixedoperatingcosts.Fixedoperatingcostsarenotincludedin
COGS(orCOSS)becausetheyarenotdirectcostsofcreatingeachproduct(or
service).
1Fixedoperatingcostsarenotincludedinothervariablecostsbecausetheydonot
varydirectlywiththenumberofsalesmade.Fixedoperatingcostsdonotchange
basedonsales;therefore,theyarenotincludedintheEOU.Asandwichshophasto
paythesamerenteachmonthwhetheritsellsoneturkeysandwichorahundred.
However,theowneroftheshopcanchangethecostoftherentbymoving,orcanin
creaseordecreasetheadvertisingbudget,andthelike.Thesechangesarenot
calculatedonaperunitbasis.

Aneasywaytorememberthesevencommonfixedoperatingcostsiswiththe
acronymUSAIIRD:
Utilities(gas,electric,telephone,Internetservice)
Salaries(indirectlabor)
Advertising
Insurance
Interest
Rent
Depreciation

Mostofthesecategoriesareselfexplanatory,butdepreciationmayneed
clarification.
Depreciationisthepercentageofvalueofanassetsubtractedeachyearuntilthe
valuebecomeszero,toreflectwearandtearontheasset.Itisamethodusedto
expense(listedasanexpenseontheincomestatement)costlypiecesofequipment.

Fixedcostsareexpensedduringtheyearthemoneyisspent.Whenacompany
paysforadvertising,itsubtractsthatcostfromthegrossprofitforthatyear.Some
items,however,suchasacomputer,areexpectedtolastforanumberofyears.A
businesscouldchoosetoexpenseacomputerduringtheyearitwasbought,butthat
wouldnotbeaccurate.Acomputerthatwillbeusedfor4yearswillhavebeenonly
25percentusedupduringtheyearitwaspurchased.Expensingtheentirecostof
thecomputerduringthatyearmakestheaccountingrecordsandfinancial
statementsinaccurate.Ifmorethan25percentofthecomputerscostisexpensedin
thefirstyear,theincomestatementwillshowalowerprofitthanitshould.
Meanwhile,profitsinsubsequentyearswillappeartobehigherthantheyshould.

Thisproblemisaddressedbydepreciation,whichspreadsthecostofanitem
purchasedbyabusinessovertheperiodoftimeduringwhichitwillactuallybein
use.Ifthecomputerwillnotbereplacedfor4years,thenthefullpriceshouldbe
shownasanassetandthenexpensed25percenteachyear.Inthisway,thecostof

thecomputeranditsvaluetothecompanywillbereflectedmoreaccurately.Fixed
OperatingCostsDoChangeOverTime
Ifyoupayyourrestaurantmanager$3,600permonthinsalary,youwillhaveto
paythatamountwhethertherestaurantsellsonemealorathousand.Thecostis
fixed.Fixedoperatingcostsdochangeovertimeatsomepointyoumaygiveyour
restaurantmanageraraise.Or,youmighthireanewmanageratalowersalary.The
wordfixeddoesnotmeanthecostneverchanges,justthatitdoesnotchangein
responsetounitsofproductionorsales.

Forinstance:
Advertising:Thecostofadvertisingwillchangebasedondecisionsthe
entrepreneurmakesabouthowmuchtospendtoreachtheconsumer,notbecause
ofcurrentsales.
HeatingandCoolingCosts:Thepriceofheatingandcoolinggoesupordownbased
ontheweatherandutilityprices,notontheamountofrevenuethebusinessearns.

AllocateYourFixedOperatingCostsWherePossible
Businessownersliketoknow,whenevertheymakeasale,howmuchofthat
revenuewillhavetobeusedtocovercostofgoodssoldandothervariablecosts.
WhateverisleftoverafteryoupaytheCOGSandothervariablecostsisyour
contributionmargin(grossprofit).Youwillpayyourfixedoperatingcostsoutof
yourcontributionmargin.Whateverisleftoverafteryoupayyourfixedoperating
costs(andtaxes)isyournetprofit.Fixedoperatingcostscanbedangerousbecause
theyhavetobepaidwhetherornotthebusinessmakesagrossprofit.The
entrepreneurshouldbecarefulabouttakingonfixedcosts,butdoesnothaveto
worrysomuchaboutvariablecostsbecause,ifsalesarelow,variablecostswillbe
lowaswell.Whereverpossible,theentrepreneurshouldseektoallocateor
distributeasmanycostsaspossiblebymakingthemvariable.

Hereisanexampleofhowtofullyallocateyourcosts,sothatyouknow,eachtime
yousellaunit,howmuchofyourfixedandvariablecoststhesalecovers.Example:
Ifyousell300watchespermonthat$15perwatch(seeFigure75),yourCOGSis$
2perwatchandyourothervariablecostsarecommissionsof$2perwatchand
shippingchargesof$1perwatch.Grossprofitperunitis$13($3,900ingross
profitdividedby300watchessold).Contributionmarginperunitis$10($3,000
300).Someofthisgrossprofitwillhavetobeusedtocoverthebusinesssfixed
operatingcosts.Itishelpfultodeterminehowmuchprofitwillbeleftoverafter
payingthefixedoperatingcosts,assumingyoursalesarestable.Figure76shows
thecalculationofthetotalcostperunit.Foreverywatchyousell,yourtotalcost,
fixedandvariable,is$6.50.Ifyoureceive$15foreachwatch,therefore,yourprofit
beforetaxisthefollowing:$15.00sellingprice$6.50totalcostperunit$8.50
profitbeforetax.

TheDangersofFixedCosts

Ifabusinessdoesnothaveenoughsalestocoveritsfixedcosts,itwilllosemoney.If
lossescontinue,thebusinesswillhavetoclose.Aswehavediscussed,fixedcostsare
dangeroustoabusinessbecausetheymustbepaidwhetherornotthebusinessis
makingenoughsalestocoverthem.Variablecosts,ontheotherhand,donot
threatenabusinessssurvivalbecausetheyareproportionaltosales.

HowInflationCanHurtSmallBusinessOwners

Inflationisthegradual,continuousincreaseinthepricesofproductsandservices,
usuallyresultingfromanincreaseintheamountofmoneyincirculationinan
economy.Itcanbetheenemyofthesmallbusinessowner.Ifyousave$600per
yeartobuynewtablesandchairs(whichcost$3,000)foryourrestaurant,butfind
attheendof5yearsthatthecostofreplacingthemhasrisenduetoinflationto
$5,000,yourbusinesscouldbeintroubleifyoucannotgettheadditional$2,000.
Savvyentrepreneurskeepupwitheconomictrendsbyreadingthefinancialsection
inthenewspapers,aswellasfinancialmagazinesandWebsites.Bystayingupto
dateonwhatishappening,entrepreneurscanplanbetterforthefutureandinvest
wisely.

UsingAccountingRecordstoTrackFixedandVariableCosts
Nowyouarereadytosetupyourfinancialrecords.Nothingthatyoulearnasan
entrepreneurwillbemoreimportantthankeepingaccuraterecordsofthemoney
flowinginandoutofyourbusiness.Thesystematicrecording,reporting,and
analysisofthefinancialtransactionsofabusiness(keepingnumericalrecordsof
inflowsandoutflows)iscalledaccounting.Itistheprimarylanguage
businesspeopleusetocommunicate.Whenyoutalktoaninvestororasupplier
aboutyourbusiness,youwillneedtousethislanguage.Heorshewillwanttosee
financialstatementsforyourbusinessthatdescribeitsperformanceataglance.

Beforeyoucancreatefinancialstatements,however,youmustbeabletokeeptrack
ofyourdailybusinesstransactions.Ifyoudeveloprecordkeepingintoahabit,you
willbewellaheadofthemanybusinesspeoplewhotendtosticktheirheadsinthe
sandwhenitcomestokeepinggoodrecordsconsistently.

ThreeReasonstoKeepGoodRecordsEveryDay
1.Keepinggoodrecordswillshowyouhowtomakeyourbusinessmoreprofitable:
Perhapsyouaremakinglessprofitthismonththanlast.Didyourexpensesgoup?
Maybeyouneedtotryloweringyourcosts.Didyoursalesdrop?Maybeyouarenot
spendingenoughonadvertising.Useaccuraterecordstoconstantlyimproveyour
business.

2.Keepinggoodrecordswilldocumentyourbusinessprofitability:Ifyouwant
peopletoinvestinyourbusiness,showthemthatitisprofitable.Keepaccurate
recordstocreatefinancialstatementsandratiosthatproveyourbusinessisdoing
well.Remember,youwillalwaysneedtomaintainyourfinancialstatementssothat
youwillbeuptodateonyourbusinessperformance.

3.Keepinggoodrecordsprovesthatpaymentshavebeenmade:Accurate,uptodate
recordshelppreventargumentsbecausetheyproveyouhavepaidabillorthata
customerhaspaidyou.Recordsalsoprovethatyouhavepaidyourtaxes,thefee
charged(levied)byagovernmentonanincome,product,oractivitythatisimposed
onanindividualorlegalentity(corporation).SometimestheInternalRevenue

Service,thefederalagencythatcollectstaxes,willvisitabusinessandcheckits
financialrecordsinaprocesscalledanaudit.Ifyoukeepgoodrecordsandpayyour
taxesinatimelyfashion,youwillhavenothingtofearfromaudits.

ExcerptedfromEntrepreneurship:StartingandOperatingaSmallBusinessSecond
EditionBySteveMariotti;CarolineGlackin