Fixed Vs Variable Costs

Introduction

Each company is faced with two types of costs: fixed and variable. Should you have more fixed or variable costs? If you are to convert to variable costs, when should you do it? What type of fixed costs do companies incur? These questions, and then some, will be addressed in this paper.

Convert to Variable Costs?

Companies with minimal fixed costs are better suited to weather the “rainy days” as compared to those that are burdened with high overhead. Fixed costs, such as rent and salaries, must be paid during good and bad economic times. Variable costs typically rise during the successful times and fall during the less successful times. Converting as much as you can to variable costs will enable you to hedge against the risk associated with fixed costs. (Causevic, n.d.)

Fixed costs include such costs as: rent, yellow pages ad, loan payments, and employee salaries. Variable costs include such costs as: supplies, electricity, collection costs, hourly employee pay, and shipping costs. One way to figure out if a cost is fixed or variable is to ask if the cost would still have to be paid if business slowed to a halt. Rent and loan payments would have to still be paid. Hourly employees could be cut, as well as supply purchases and the shipping of product. If business slowed to a halt, and you had minimized your fixed costs, then you would be in a better position than if you had not. (Causevic, n.d)

When to Switch to Variable Costs

A company should switch to variable costs when it seeks to hedge against the risk of fixed costs and when it wants to more effortlessly estimate, track, and manage those costs. In order to do this, you must unmistakably understand the factors that drive the variable costs and how they have an effect on the business. You must also constantly check variable costs to determine if they are adding value to the business. The evaluation of your products and services regularly is important too; in an effort to determine which are the most and least profitable. In addition, you must make certain that your cost and management system is operating as effectively and efficiently as possible. (Causevic, n.d.)

When you clearly understand the cost drivers, you can more easily control them. Evaluating costs should not just be done in poor economic times as cost management is a continuous process. After evaluating your products and services, thus finding out which are the most profitable, you can channel our available resources towards increasing the volume in these areas, and decreasing the volume in the less profitable areas. Finally, you can operate more effectively and efficiently by implementing software to reduce time spent handwriting orders, looking up client records, etc. (Causevic, n.d.)

Businesses’ Fixed Costs

Companies have a variety of fixed costs. These costs include: rent, property tax, insurance, 401(k) matches, exempt employee salaries, loan payments, and any other costs that do not vary depending on production or sales levels. (Fixed, 2009) In times of high sales and profits, companies can make an effort to purchase the building(s) it occupies outright and pay off outstanding loans in an effort to reduce these fixed costs. This would free up more money for variable costs as well as free up more money for the company to reinvest that money in itself for growth.

Conclusion

Converting as much as you can from fixed costs to variable costs is a great idea. This will enable you to better withstand poor economic times, like those that are currently upon us. In addition, during times of good economic times, when sales are abundant, you will have more money available for higher commissions and to reinvest in the company for further growth. My recommendation would be to start switching to variable costs by first paying down outstanding loans and seeking to purchase our occupied building(s) outright.

References

Causevic, E. (n.d.) Fixed vs. variable: Prune costs to grow your practice. Retrieved January 21, 2009, from http://www.chiroeco.com/article/2005/issue6/Prune.php

Fixed cost. (2009). Retrieved January 21, 2009, from http://www.investorwords.com/1992/fixed_cost.html