All you need to know about fixed and variable costs

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All you need to know about fixed and variable costs

Starting a small business in New Zealand can be exciting and challenging at the same time. While New Zealand is known for its business-friendly environment, a key aspect that new business owners cannot underestimate relates to estimating the costs of setting up and running the company. Neglecting to accurately estimate hidden and obvious costs of running a business has a dramatic impact on profitability, short and long-term business growth prospects.

Having a solid grasp of the fixed and variable costs of operating your business is crucial to the success of your venture.

The crucial break-even point

Running a successful business is all about ensuring your business is profitable. This entails estimating your expenses – both capital and ongoing – and forecasting your revenue from different sources. The break-even point is reached when you are able to sell enough to cover the operating costs. Once you reach the break-even point, your business is officially turning a profit.

Knowing how or when you will reach the break-even point is important to plan ahead for your company’s growth or make decisions that influence the profit margin.

An accurate estimate of your expenses – that includes both fixed and variable costs – is a critical aspect of achieving the break-even point.

Fixed costs

Fixed cost refers to expenses that stay the same regardless of the business output, for example, rent, loan payments, and salaries.

Listing the ongoing monthly predictable expenses helps you accurately calculate your break-even point. Make a list of all the ongoing predictable costs that include:

  • Leased or rented office space
  • Leased or rented retail space
  • Office expenses
  • Utilities including phone service, electricity, heat, internet
  • Employee salaries -Whether you hire full-time employees or freelancers, you will have to factor in the current salary scale or consultancy fee.
  • Marketing expenses – From designing your business website, advertising in social media channels to other digital marketing strategies, sales, and marketing account for significant fixed expenses.
  • Liability insurance-Depending on your industry and risk protection needs, you may need to purchase specific types of small business insurance. The different types of insurance include public liability insurance, professional indemnity insurance, cyber liability insurance, statutory liability, and employer’s liability insurances.
  • Professional fee -Fixed costs can also include the expenses related to hiring legal experts, accountants, and other industry-specific experts.

While adding the fixed costs, try to be as accurate as possible. Factoring an additional 10 percent to the fixed costs can help cover unforeseen expenses.

Variable costs

Variable costs are those that change in proportion to the changes in sales volume or business activity level. Expenses related to taxes, direct labor, and operational expenses are examples of variable costs. Make a list of your variable costs as well by listing down the expenses related to

  • Inventory
  • Shipping costs
  • Labor
  • Delivery fees
  • Commissions
  • Delivery fees
  • Business loan/line of credit interest rates

Calculating an average monthly variable expense based on a 2 to 3-month period can help you arrive at precise variable cost estimates.

Calculating break-even point using fixed and variable costs

A simple formula you can use to calculate the break-even point is

fixed costs/unit sales price – variable costs

  1. your company’s fixed overhead costs
  2. the price of each item for sale
  3. each unit’s variable costs

For example, a web designer offers web design packages that are priced $5,000 per package (unit sales price). His fixed operating costs are $8000 and variable costs per unit/web package are $1000. Substitute these figures into the formula:

$8000/$5000-$1000 = 2

As per this calculation, the web designer reaches a break-even point and starts making a profit by selling 2 website packages.

Factor in semi-variable costs

Semi-variable costs have the elements of both variable and fixed costs. Employee bonuses are a prime example of semi-variable costs. You may need to pay a bonus to your well-performing employees each month, every quarter, or annually.

For certain types of businesses, costs of utilities can also come under semi-variable costs. For instance, a production facility may incur $1000 each month as energy costs to function at a minimal level. In case the production is scaled up, additional machinery or equipment will be used which can increase electricity costs to $2000 a month. Commissions paid to contract workers or consultants will also count as semi-variable expenses.

Conclusion

Estimating your fixed and variable costs accurately is key to ensuring there are no unpleasant surprises down the line. While you cannot predict all the risks that come your way, public liability claims often arise due to defective products, services, third-party property damage, injury, or illness. Buying public liability insurance is the best way to avoid massive expenses related to compensation and the legal costs of defending yourself against these claims.