And why are variable costs important?
Most bookkeepers and accountants do not separate variable and fixed costs on small and mid-sized businesses’ financial books. Even some of the $100 million+ companies I banked had a CFO that did this… Why?
Variable costs are the costs associated with producing and selling your product – Cost of Goods and/or Cost of Sales. These include materials, labor, sales commissions, transportation costs, etc. Almost anything having to do with delivering the product/service to the customer.
Variable costs increase with the growth of revenues and decrease with a decline – or at least they should! That’s why they are variable – they change based on sales.
Fixed costs are the costs of doing business – the back office including rent, insurance, software, utilities, phones, owner’s salary and any other office people like A/R or A/P clerks.
Fixed costs stay relatively steady whether you have sales of $1 million or $3 million.
Why is this important?
• Pricing your product or service is usually done based on Variable Costs. Many business owners forget to add the 20% to 30% fixed expense to their calculations. Therefore, they are surprised when only 20% of their clients are profitable… They were not using complete information.
• Managing your efficiencies requires measuring productivity. Separating variable from fixed enables the productivity/employee to be more accurate. For example, salespeople and consultants are expected to earn 3X to 10X their salaries. These numbers can be carefully monitored to determine if new hires are needed or if employees are working up to expectations.
• Budgeting, growth and RIFs. To budge accurately, variable costs will move with revenue but fixed costs should remain fairly flat.
Restructuring your income statement to accurately reflect variable and fixed costs should be done by the owner or CFO or financial employee. Leave the accountant’s preparation of your financials as they are. You do not want to make changes that could impact your tax returns in any way. Just put together what I call a Management Financial Statement and monitor it monthly.
If this is not your practice, consider joining a BOMBA Mastermind or Financial Bootcamp. We will teach you how to read your financials, set up your Management Financial Statements, and make better financial and business decisions.
Have you tried this? Did it help you? Or was it too confusing? How do you know which employees are making you money without these tools? I would love to hear your feedback.
Want to talk further about this subject?
Contact me and book a time or consider joining a BOMBA Mastermind where you will get the tools to complete the sensitivity analysis on the margin compression and you can talk confidentially to a peer group who could give you constructive feedback on your pricing.