Designing your Cost Structure for Optimum Profits
Most small businesses do not need help controlling their costs. Since the owner is involved in daily operations, they know what is going on in the bank account. But, there is a factor in controlling costs that most business owners miss – that is the variable vs. fixed costs factor.
Variable costs are costs that vary with the amount of output being produced. Examples include sales commissions, product, and shipping costs. Fixed costs are those costs that you incur regardless of whether you sold anything. Rents, equipment depreciation, and salaries are examples of fixed costs. The planning opportunity is how to structure your various costs between being fixed or variable.
Many times, you have a choice on whether to make a cost fixed or variable. You could hire a full-time employee to do certain tasks or you could hire a contractor. Employee salaries are fixed, while most contractor fees tend to be on a per job bases and vary with the output.
Once a company with high fixed costs and low variable costs has enough sales to cover those fixed costs, their lower variable costs are going to produce much higher profits than a company that is structured the other way. Of course, there is the opposite side of this formula. If the high fixed costs company does not reach their break even point, their losses will be greater than the low fixed cost company.
How should you use this in business planning? You need to consider the business cycle. Business cycles are an integral part of Capitalism. When times are good, marginally profitable companies can exist. But, eventually their numbers build up and begin to put a drag on the economy until enough of these companies fail and the survivors will once again begin to grow. If the economy is slow or in recession, it’s a great time to be making your costs fixed. Lots of people are willing to work for less and will happily sign long-term agreements to that effect. Conversely, if the economy is booming like it is today, making as many of your costs variable is a good move. That next recession is coming and having a high variable cost rate is an advantage when sales begins to slide.