David Brown: What to Do When Fixed Becomes Variable

Planning for changing expenses can save your cash flow

It’s important to realize that costs come in two distinct types — fixed and variable. Fixed costs are those expenses that don’t change no matter how much you sell. Examples of fixed costs include insurance and fixed staff wages. Whether you sell anything today or not you have to meet these expenses. The good news, however, is that if you increase sales these costs don’t increase so your profit is greater.

Variable costs are expenses that will change or vary as your income changes. Examples include commissions, bank fees and, of course, your biggest, the cost of sales. Although these expenses can be low, and sometimes zero, if you don’t sell anything, you need to remember that as sales increase so do your expenses in these areas — profit isn’t always equal to the extra margin you might make on each additional sale.

In reality, many expenses are a hybrid — they can be a little bit fixed and a little bit of variable. If you pay your staff a set wage but offer an incentive when sales are beyond a certain level then this is a hybrid — fixed to a certain point but then becoming a variable cost beyond that. Rent — if you are on a fixed minimum rent with a percentage of sales beyond another level — is another example. Even bank fees are hybrid — ask your bank manager if he won’t charge you anything if you don’t make a sale and watch the expression on his face!

The important thing is to understand this when setting your margins. Many business owners set their margins to allow for their existing cost structure but forget that some expenses will change if they achieve certain levels of sales. When your sales move beyond a certain level and you trigger the increase clause in your rental agreement this becomes a significant cost increase. Are you allowing for this in your pricing?

Grab last year’s financial statements and look at your list of expenses. Take a blue highlighter and mark those expenses that are fixed regardless of changes in sales. Now use a red highlighter to mark the hybrids and variable expenses and take note at what point they may change. Are they significant? A surge in stationery consumption probably won’t matter. But your commission and rent trigger points might be very significant depending on how close you are to them.

A little awareness in this area can help you plan your cash flows better and define the markup you need to stay profitable.