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Fixed
and
Variable
Costs:
Essential
Building
Blocks
Small
business


owners
divide
their
costs
into
two
categories.
Variable
costs
change
based
on
the
 volume
of
units
sold.
Fixed
costs
must
be
paid
regardless
of
whether
or
not
sales
are
 being
generated.
 
 Variable
costs
change
with
sales.
They
fall
into
two
subcategories:
 
1.
Cost
of
goods
sold
(
COGS),
or
cost
of
services
sold
(
COSS),
which
is
associated
 specifically
with
each
unit
of
sale,
including:
•
The
cost
of
materials
used
to
make
the
 product
(
or
deliver
the
service)
•
The
cost
of
labor
used
to
make
the
product
(
or
 deliver
the
service)

 2.
Other
variable
costs
include:
•
Commissions
or
other
compensation
based
on
 sales
volume
•
Shipping
and
handling
charges

 
 Fixed
costs
stay
constant
whether
you
sell
many
units
or
very
few.
 Examples
of
fixed
costs
include
rent,
salaries,
insurance,
equipment,
and
 manufacturing
plants.
Henry
Ford
spent
money
on
efficient
manufacturing
 equipment
(
a
fixed
cost)
but
saved
a
fortune
on
labor
(
COGS)
by
doing
so.
This
 reduced
his
total
costs
because
labor
was
used
in
each
of
the
millions
of
cars
Ford
 produced,
but
he
only
had
to
pay
for
the
plant
and
equipment
once.
For
any
unit
of
 sale,
you
can
study
its
Economics
of
One
Unit
to
figure
out
what
it
cost
to
make
that
 sale.
Figure
7‐
2
shows
an
example
from
a
business
that
sells
hand‐
painted
vintage
 T‐
shirts.
 



 
 



and
as
long
as
Jamaal
sells
roughly
the
same
number
of
 each
brand
of
bar.
Costs
of
the
four
candy
bars
(
36¢
38¢
42¢
44¢)
÷
4
Average
 cost
of
the
four
candy
bars
$
1.
Example:

 Jamaal
sells
four
kinds
of
candy
bars
at
school.60
÷
4
Average
cost
of
each
bar
40¢
Using
an
average
 works
if
the
costs
are
close.

 
 .
A
business
selling
a
variety
of
products
has
to
create
a
separate
EOU
for
 each
product
to
deter‐mine
whether
each
one
is
profitable.
He
sells
each
bar
for
$
1.
he
should
then
change
his
EOU
to
reflect
the
higher
price
of
the
other
two
 bars.

 
 
 
 What
if
each
unit
of
sale
is
made
up
of
a
complex
mix
of
materials
and
labor?
The
 EOU
can
still
help
you
figure
the
COGS.
a
“
typical
EOU”
can
be
 used.
for
 example.
and
gross
profit
for
the
 product.
other
variable
costs.Calculating
EOU
When
You
Sell
More
Than
One
Product
Most
businesses
sell
more
 than
a
single
product
and
they
also
can
use
EOU
as
a
value
measure
of
product
 profitability.
although
the
process
will
be
more
complex.
If
he
can
no
longer
get
Snickers
and
Almond
Joy
at
some
point.
Jamaal
uses
the
average
cost
of
his
four
candy
 bars
(
see
Figure
7‐
3).
but
 he
pays
a
different
wholesale
price
for
each:

 Snickers
36¢
each

 Almond
Joy
38¢
each

 Butterfinger
42¢
each

 Baby
Ruth
44¢
each

 
 Rather
than
make
separate
EOUs.
When
there
are
many
 similar
products
with
comparable
price
and
cost
structures.


 
 
 
 Other
Variable
Costs
The
following
supplies
are
used
every
time
a
sandwich
is
sold.
such
as
napkins.).
There
will
also
be
some
other
 variable
costs.
One
roll
is
used
per
sandwich.
The
costs
of
the
materials
and
direct
labor
for
production
 are
called
inventory
costs
until
the
product
is
sold.
and
any
other
variable
costs:
COGS
a.
make
a
list
of
the
COGS.
Each
sandwich
uses
a
fourth
of
a
tomato.)
The
EOU
for
the
turkey
sandwich
is
shown
 in
Figure
7‐
4.
Employees
are
paid
$
 7
per
hour
and
can
make
10
sandwiches
per
hour
(we
are
assuming
no
down
time
 and
no
payroll
costs).
A
32‐
ounce
jar
of
mayo
costs
$
1.
Pickles
cost
5
cents
each.
 She
sells
each
for
$
5.
Bread
 (large
rolls)
cost
$
1./
1
lb.
 
 
 
 
 .
 but
are
not
strictly
part
of
the
sandwich’s
production:
a.
Paper
wrapping
costs
20
cents
per
 foot
(on
a
roll).Example:
Denise
sells
turkey
sandwiches
from
her
deli
cart
downtown
on
Saturdays.16
each.60
per
lb.
of
turkey
meat
(
16
oz.
Napkins
cost
$
3
per
pack
of
 100.
One
napkin
is
included
with
each
sale.
Turkey
 costs
$
2.
 Tomatoes
cost
$
1.
more
 than
one
sandwich
might
go
into
a
bag.
g.
(In
reality.
Each
sandwich
uses
two
feet
of
paper.
b.
b.
First.
Each
sandwich
uses
4
oz.
c.
d.
and
plastic
 bags.
Each
sandwich
sold
uses
one
plastic
carryout
bag.60.
Each
 sandwich
comes
with
two
pickles.
The
materials
and
labor
that
go
directly
into
making
each
 sandwich
are
the
COGS.
One
ounce
of
 mayonnaise
is
used
per
sandwich.
Plastic
carryout
bags
cost
$
 7
per
roll
of
100.
e.
c.
and
1/
16
of
a
pound
(1
ounce)
is
used
on
each
sandwich.
Lettuce
 costs
80
cents
per
lb.92
per
dozen.
a
paper
wrapping
for
each
sandwich.
f.



 
 This
problem
is
addressed
by
depreciation.
Internet
service)

 Salaries
(indirect
labor)

 Advertising

 Insurance

 Interest

 Rent

 Depreciation

 
 Most
of
these
categories
are
self‐
explanatory.
Fixed
operating
costs
do
not
change
 based
on
sales.
A
computer
that
will
be
used
for
4
years
will
have
been
only
 25
percent
“
used
up”
during
the
year
it
was
purchased.
A
 business
could
choose
to
expense
a
computer
during
the
year
it
was
bought.
but
depreciation
may
need
 clarification.
or
can
in‐ crease
or
decrease
the
advertising
budget.
which
spreads
the
cost
of
an
item
 purchased
by
a
business
over
the
period
of
time
during
which
it
will
actually
be
in
 use.
 
 An
easy
way
to
remember
the
seven
common
fixed
operating
costs
is
with
the
 acronym
USAIIRD:

 Utilities
(gas.
Expensing
the
entire
cost
of
 the
computer
during
that
year
makes
the
accounting
records
and
financial
 statements
inaccurate.
profits
in
subsequent
years
will
appear
to
be
higher
than
they
should.

 1
Fixed
operating
costs
are
not
included
in
other
variable
costs
because
they
do
not
 vary
directly
with
the
number
of
sales
made.
These
changes
are
not
 calculated
on
a
per‐
unit
basis.
Fixed
operating
costs
are
not
included
in
 COGS
(or
COSS)
because
they
are
not
direct
costs
of
creating
each
product
(
or
 service).
A
sandwich
shop
has
to
 pay
the
same
rent
each
month
whether
it
sells
one
turkey
sandwich
or
a
hundred.
telephone.
In
this
way.

 
 Fixed
costs
are
“
expensed”
during
the
year
the
money
is
spent.
If
more
than
25
percent
of
the
computer’s
cost
is
expensed
in
 the
first
year.
 However.
and
the
like.
it
sub‐tracts
that
cost
from
the
gross
profit
for
that
year.
however.
they
are
not
included
in
the
EOU.
to
reflect
wear
and
tear
on
the
asset.
If
the
computer
will
not
be
replaced
for
4
years.

 Depreciation
is
the
percentage
of
value
of
an
asset
subtracted
each
year
until
the
 value
becomes
zero.
then
the
full
price
should
be
 shown
as
an
asset
and
then
expensed
25
percent
each
year.Fixed
Operating
Costs

 Costs.
the
cost
of
 .
but
that
 would
not
be
accurate.
Some
 items.
such
as
a
computer.
the
owner
of
the
shop
can
change
the
cost
of
the
rent
by
moving.
When
a
company
 pays
for
advertising.
such
as
rent
or
the
Internet
bill.
therefore.
are
called
fixed
operating
costs.
electric.
which
do
not
vary
per
unit
of
production
or
 service.
the
income
statement
will
show
a
lower
profit
than
it
should.
It
is
a
method
used
to
“
 expense”
(listed
as
an
expense
on
the
income
statement)
costly
pieces
of
equipment.
 Meanwhile.
are
expected
to
last
for
a
number
of
years.



 
 Allocate
Your
Fixed
Operating
Costs
Where
Possible

 Business
owners
like
to
know.900
in
gross
 profit
divided
by
300
watches
sold).50
 profit
before
tax.
Gross
profit
per
unit
is
$
13
($
3.
your
total
cost.
whenever
they
make
a
sale.50
total
cost
per
unit
$
8.
Whatever
is
left
over
after
you
pay
your
fixed
operating
 costs
(and
taxes)
is
your
net
profit.
not
on
the
amount
of
revenue
the
business
earns.
your
COGS
is
$
 2
per
watch
and
your
other
variable
costs
are
commissions
of
$
2
per
watch
and
 shipping
charges
of
$
1
per
watch.
each
time
 you
sell
a
unit.
Figure
7‐
6
shows
 the
calculation
of
the
total
cost
per
unit.
just
that
it
does
not
change
in
 response
to
units
of
production
or
sales.
You
will
pay
your
fixed
operating
costs
out
of
 your
contribution
margin.
variable
costs
will
be
 low
as
well.
you
might
hire
a
new
manager
at
a
lower
salary.
how
much
of
your
fixed
and
variable
costs
the
sale
covers.
The
 word
fixed
does
not
mean
the
cost
never
changes.50.

 •
Heating
and
Cooling
Costs:
The
price
of
heating
and
cooling
goes
up
or
down
based
 on
the
weather
and
utility
prices.00
selling
price
–
$
6.
The
 entrepreneur
should
be
careful
about
taking
on
fixed
costs.
how
much
of
that
 revenue
will
have
to
be
used
to
cover
cost
of
goods
sold
and
other
variable
costs.
 
 .000
÷
 300).
 fixed
and
variable.
you
will
have
to
 pay
that
amount
whether
the
restaurant
sells
one
meal
or
a
thou‐sand.
The
cost
is
 fixed.
your
profit
 before
tax
is
the
following:
$
15.
For
every
watch
you
sell.
Wherever
possible.
is
$
6.600
per
month
in
salary.
the
entrepreneur
should
seek
to
allocate
or
 distribute
as
many
costs
as
possible
by
making
them
variable.the
computer
and
its
value
to
the
company
will
be
reflected
more
accurately.

 
 For
instance:

 •
Advertising:
The
cost
of
advertising
will
change
based
on
decisions
the
 entrepreneur
makes
about
how
much
to
spend
to
reach
the
consumer.
so
that
you
know.
Some
of
this
gross
profit
will
have
to
be
used
to
cover
the
business’s
fixed
 operating
costs.
Fixed
operating
costs
do
change
over
time—
at
some
point
you
may
give
your
 restaurant
manager
a
raise.
Or.
not
because
 of
current
sales.
but
does
not
have
to
 worry
so
much
about
variable
costs
because.
It
is
helpful
to
determine
how
much
profit
will
be
left
over
after
 paying
the
fixed
operating
costs.
Contribution
margin
per
unit
is
$
10
($
3.
 Whatever
is
left
over
after
you
pay
the
COGS
and
other
variable
costs
is
your
 contribution
margin
(gross
profit).
therefore.
if
sales
are
low.
Example:
 If
you
sell
300
watches
per
month
at
$
15
per
watch
(see
Figure
7‐
5).
assuming
your
sales
are
stable.
Fixed
 Operating
Costs
Do
Change
Over
Time

 If
you
pay
your
restaurant
manager
$
3.

 
 Here
is
an
example
of
how
to
fully
allocate
your
costs.
If
you
receive
$
15
for
each
watch.
Fixed
operating
costs
can
be
dangerous
because
 they
have
to
be
paid
whether
or
not
the
business
makes
a
gross
profit.


Variable
costs.
fixed
costs
are
 dangerous
to
a
business
because
they
must
be
paid
whether
or
not
the
business
is
 making
enough
sales
to
cover
them.
on
the
other
hand.
 
 
 
 The
Dangers
of
Fixed
Costs

 If
a
business
does
not
have
enough
sales
to
cover
its
fixed
costs.
the
business
will
have
to
close.
it
will
lose
money.
As
we
have
discussed.
do
not
 threaten
a
business’s
survival
because
they
are
proportional
to
sales.

 
 
 .
If
 losses
continue.


or
activity
that
is
imposed
 on
an
individual
or
legal
entity
(
corporation).
It
can
be
the
enemy
of
the
small
business
owner.

 
 Three
Reasons
to
Keep
Good
Records
Every
Day

 1.
the
fee
 charged
(levied)
by
a
government
on
an
income.
 Savvy
entrepreneurs
keep
up
with
economic
trends
by
reading
the
financial
section
 in
the
newspapers.
Did
your
expenses
go
up?
 Maybe
you
need
to
try
lowering
your
costs.
 usually
resulting
from
an
increase
in
the
amount
of
money
in
circulation
in
an
 economy.
but
find
 at
the
end
of
5
years
that
the
cost
of
replacing
them
has
risen—
due
to
inflation—
to
 $
5.000.
Use
accurate
records
to
constantly
improve
your
 business.
Nothing
that
you
learn
as
an
 entrepreneur
will
be
more
important
than
keeping
accurate
records
of
the
money
 flowing
in
and
out
of
your
business.
continuous
increase
in
the
prices
of
products
and
services.
reporting.
Keep
accurate
 records
to
create
financial
statements
and
ratios
that
prove
your
business
is
doing
 well.
you
will
need
to
use
this
language.
He
or
she
will
want
to
see
 financial
statements
for
your
business
that
describe
its
performance
at
a
glance.

 
 3.
however.
entrepreneurs
can
plan
better
for
the
future
and
invest
 wisely.
If
you
develop
record
keeping
into
a
habit.
Keeping
good
records
proves
that
payments
have
been
made:
Accurate.
By
staying
up
to
 date
on
what
is
happening.

 
 Before
you
can
create
financial
statements.
you
will
always
need
to
maintain
your
financial
statements
so
that
 you
will
be
up
to
date
on
your
business
performance.

 
 Using
Accounting
Records
to
Track
Fixed
and
Variable
Costs
 Now
you
are
ready
to
set
up
your
financial
records.
Sometimes
the
Internal
Revenue
 .
Did
your
sales
drop?
Maybe
you
are
not
 spending
enough
on
advertising.
and
 analysis
of
the
financial
transactions
of
a
business
(keeping
numerical
records
of
 inflows
and
outflows)
is
called
accounting.
The
systematic
recording.
If
you
save
$
600
per
 year
to
buy
new
tables
and
chairs
(which
cost
$
3.
Records
also
prove
that
you
have
paid
your
taxes.000)
for
your
restaurant.
as
well
as
financial
magazines
and
Web
sites.
It
is
the
primary
language
 businesspeople
use
to
communicate.
When
you
talk
to
an
investor
or
a
supplier
 about
your
business.
product.
Keeping
good
records
will
document
your
business
profitability:
If
you
want
 people
to
invest
in
your
business.
show
them
that
it
is
profitable.000.

 
 2.
you
must
be
able
to
keep
track
 of
your
daily
business
transactions.How
Inflation
Can
Hurt
Small
Business
Owners

 Inflation
is
the
gradual.
your
business
could
be
in
trouble
if
you
cannot
get
the
additional
$
2.
you
 will
be
well
ahead
of
the
many
businesspeople
who
tend
to
stick
their
heads
in
the
 sand
when
it
comes
to
keeping
good
records
consistently.
up
to
date
 records
help
prevent
arguments
because
they
prove
you
have
paid
a
bill
or
that
a
 customer
has
paid
you.
Remember.
Keeping
good
records
will
show
you
how
to
make
your
business
more
profitable:
 Perhaps
you
are
making
less
profit
this
month
than
last.


will
visit
a
business
and
check
its
 financial
records
in
a
process
called
an
audit.
If
you
keep
good
records
and
pay
your
 taxes
in
a
timely
fashion.
you
will
have
nothing
to
fear
from
audits.
the
federal
agency
that
collects
taxes.
 
 
 Excerpted
from
Entrepreneurship:
Starting
and
Operating
a
Small
Business
Second
 Edition
By
Steve
Mariotti.Service.
Caroline
Glackin
 .