Fixed and Variable Costs

Before you can use cost/volume/profit analysis to help you evaluate your business's operations, you need to get a handle on the fixed costs of your business, as compared to your variable costs.

Virtually all of your business's costs will fall, more or less neatly, into one of two categories:

• "Variable costs," which increase directly in proportion to the level of sales in dollars or units sold. Depending on your type of business, some examples would be cost of goods sold, sales commissions, shipping charges, delivery charges, costs of direct materials or supplies, wages of part-time or temporary employees, and sales or production bonuses.
• "Fixed costs," which remain the same regardless of your level of sales. Depending on your type of business, some typical examples would be rent, interest on debt, insurance, plant and equipment expenses, business licenses, and salary of permanent full-time workers.

Your accountant can help you determine which of your costs are fixed and which are variable, but here the key word is "help." In order to be accurate, the ultimate classification has to be done by someone who's intimately familiar with your business operations — which probably means you.

Combination costs. Some costs are a combination of fixed and variable: a certain minimum level will be incurred regardless of your sales levels, but the costs rise as your volume increases. As an analogy, think about your phone bill: you probably pay an access or line charge that is the same each month, and you probably also pay a charge based on the volume of calls you make. Strictly speaking, these costs should be separated into their fixed and variable components, but that may be more trouble than it's worth for a small business. To simplify things, just decide which type of cost (fixed or variable) is the most important for the particular item, and then classify the whole item according to the more important characteristic. For example, in a telemarketing business, if your phone call volume charges are normally greater than your line access charges, you'd classify the entire bill as variable.

Relevant range of activity. It's important to realize that fixed costs are "fixed" only within a certain range of activity or over a certain period of time. For example, your rent is a constant amount per month — until your landlord raises it at the end of the year — unless you go out of business completely, in which case it would drop to zero, or unless your sales increase to the point where you need to rent an additional workplace, in which case it might double. So CVP analysis is only valid within a certain range of sales (generally, this coincides with the range that could reasonably be expected for your business) — at the extreme high and extreme low ends of the range, or if enough time passes, all costs become variable.

Cost per unit or job. If you add up all your variable costs for the accounting period, and divide by the number of units sold, you will arrive at the cost per unit. This cost should remain constant, regardless of how few or how many units you sell. If yours is a service business, you may be able to divide your variable costs by the number of jobs performed (if the jobs are essentially similar) or by the hours spent on all jobs (if the jobs vary greatly in size).

Once you're comfortable with classifying costs as fixed or variable, you can apply this knowledge with two techniques: contribution margin analysis and breakeven analysis.