One of the key principles to managing your business effectively is analyzing expenses to determine an appropriate budget and forecast. In order to understand your cost commitments and develop a base line forecast, it is important to first identify your fixed cost vs variable cost.
Fixed Costs are those expenses that do not change in relation to the activity of the business. These costs would be incurred regardless of the amount of sales or work performed.
They are generally your weekly, monthly, or annually general and administrative expenses. For example, your monthly office space lease payment will remain consistent with the terms set forth in your lease regardless of an increase or decrease in sales each month.
Other examples would include employee salaries, office equipment leases, utilities, depreciation, etc. Although these costs will vary over time, they are not directly related to the performance over a specific period or tied to the sale of a good or service.
Variable Costs are expenses that will vary over a specified period in relation to the performance of the business. These expenses are generally considered Cost of Goods Sold (COGS) and are directly associated to the activity of a business in a given period.
For example, if sales of a particular item increase over a specified period you would also expect to experience an increase in the raw material cost associated in constructing each component of that finished good. As your company activity changes over time, you will also see fluctuations in these variable costs. Other examples of variable costs include direct labor, inbound freight, purchased finished goods, etc.
Understanding the distinction between these different types of expenses and your recurring costs will help build an effective budget and cash flow forecast for your business.
Additionally, understanding your fixed cost commitments and variable cost trends will allow you to analyze month over month fluctuations and identify variances from your forecast. Using these principles will allow you to effectively manage your business and influence decision making to insure the future health of your business.