Fixed and Variable Costs

Most of us have a pretty good idea what "costs" are right? I mean when you go to the store to buy something, it costs money. Pretty straight forward stuff.

When you are in business however, you need to recoup these costs from the customer plus a profit margin or you are not going to stay in business very long! So let's take a quick look at costs.

In its most basic form, there are three kinds of costs:

  • Fixed Costs
  • Variable Costs
  • Overhead Costs

Fixed Costs

Fixed costs are those costs that are not dependent on the production of your product. In other words, these costs stay the same whether you produce one car or many cars. An example of this might be the rent on your workspace. Whether you are producing anything or not, you still have to pay the rent every month so for all intents and purposes your rent is a fixed cost.

If you think about it - your fixed cost is almost like a "floor" that you have to get above before you even have a chance of making any profit. Sometimes borrowing costs can be included in the fixed cost category and often it is these costs that cause a business to fail. If you can't pay your creditors every month, then they have the right to call their loan which in essence means ask for all of their money back. If you don't have the money to give back - well it's - Chapter 11 time or bankruptcy.

Variable Costs

Variable costs are costs that are dependent on the production of a product for example, the material to build it and the labor to put it together. You can easily see that if there is $10 worth of material in a car then there will be $20 worth of material in two cars and so on. The same holds true for the cost of labor to build the car. These are called variable costs because they vary with the level of production. Keep in mind that if you have no production, you will theoretically not have any production costs but you will still have your fixed costs.

Overhead Costs

Overhead costs can fall into a fixed cost category but I like to separate them out because it is a term you will hear of quite frequently in business. In the most fundamental way, overhead costs are similar to fixed costs because there are usually some overhead costs associated with any business. However, the amount of overhead can also be a function of production which can cause them to behave almost like variable costs. So obviously an example or two might be useful here.

Examples of overhead costs might include functions like information technology, human resources, administration and leadership. At some point in your business you are going to need some of this organizational "infrastructure" and so you will hire an IT guru to manage your information technology and once you get to a certain point, you will also need an HR person to handle your payroll, administer your benefit plan and create HR policies etc.

Overhead costs are usually a function of organizational size so they are not solely a fixed costs but nor are they purely a function of production. They are incurred almost in a step like fashion based on the size of your organization.

For example, when an entrepreneur starts out - he or she is the entire business. But as the business grows, they may hire a few people to help do the work. As the business grows further, the first overhead cost is incurred because the entrepreneur now no longer does "the work" but oversees the work of others. This is the first step in the overhead cost staircase.

As the business continues to grow, the owner needs a part time IT person and a part time HR person and likely an administrator of some sort to keep track of all the paper work. This is the second step in the overhead ladder and so it goes.

Now some businesses consider these overhead costs as "fixed costs" and so any sale of a unit of product has to first offset the true fixed costs and then the overhead costs and then the production costs before any profit can be considered.

Other businesses prefer to distribute their overhead costs to make them kind of like variable costs. In this case, they will look at their total overhead costs and divide them by the number of units of production. This is neither right nor wrong - it is just another way of accounting for these costs, however you can easily see that the cost per unit produced goes down as the number of units increases because the overhead is distributed based on how many units are produced.

For example, $10 of overhead distributed over a production run of one, will cause the cost of that unit of production to go up by $10! However, if the overhead costs are distributed over a production run of 10 units, then the overhead costs is only $1 per unit!

So let's wrap this section up by understanding that:

Product Cost = Fixed Cost + Variable Cost + Overhead Cost

And by the same token,

Price of Product = Product Cost + Profit Margin

So the Break Even Point is when you have sold enough product to cover off all of your fixed costs and your variable costs and your overhead costs. The next unit sold will deliver a profit to your business!


Depreciation

Okay I also have to mention the cost of depreciation.

Depreciation is the cost associated with the decline in value of any tools, equipment, machinery or material used in the production of your product.

An easy example. When you buy a car, you may pay $40,000 but a year later that same car has depreciated to say $32,000 because it has been used. Where did the $8,000 go? It is the depreciation cost and it needs to be accounted for.

Now sometimes, businesses can change the rate of depreciation of their assets to make their company look better in their financial reports. This is poor accounting practice but that is not to say it is never done.

To understand why this is important, it is necessary to look at the total value of a company. This value will include things like:

  • cash on hand or in the bank,
  • accounts receivable (money billed but not yet received)
  • and the value of the assets owned.

less any moneys owed, accounts payable etc.

So if you want to inflate the value of your company to fool your investors, one thing you can do is increase the value of the assets you own. How? Depreciate them less than expected!

Using the car example, instead of reporting the value of the asset at $32,000 we could instead say that the market value is higher and the depreciation on this model lower so that we report its value as $35,000. As a result our reported value of our assets goes up and our company appears more valuable.

You can see how important depreciation is when you consider asset intensive businesses that own factories, airplanes, pipelines, power plants etc. These are big ticket items and a few percentage points change in depreciation can be the difference between an apparently "healthy" company and a "sick" one.


GAAP

What the heck is GAAP? Well this might be hard to believe but there is no one standard for accounting practices such as how to account for depreciation as explained above. What we do have is GAAP which stands for:

Generally Accepted Accounting Practices.

So there is a book of standards that accountants are encouraged to use in their work but keep in mind this is not book keeping and there is a lot of judgment and analysis that goes into accounting to make sure that the numbers reported are accurate and perhaps even more importantly consistent from year to year.

The Sarbanes-Oxley Act introduced in the US was designed to improve the accountability of Chief Financial Officers and Controllers. It is a much more rigorous set of standards that all publicly traded companies in the US must adhere to. It is also referred to as SOX. If you want more info on this, I would suggest Googling it as I am anything but an expert on this.

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