Posts Taged variable-costs

The One Year, Thirty Minute Challenge :: Week Three :: Finance :: Fixed Costs vs Variable Costs

I hesitated to do this one and especially hesitated to do it early in The One Year, Thirty Minute Challenge because it surfaces most frequently with solopreneurs (or those with just a handful of employees). Larger and older companies have already figured it out or else they wouldn’t still be around. However, when I’ve seen it with past clients and corrected it, the results were so dramatic (it’s been the difference between staying in business and going out of business), I felt like I had to share it early on.

It’s really just a math problem. Instead of explaining, let me illustrate and then give the steps for this week’s exercise.

ABC Company charges $60/hour for their widget repairing service. ABC Company is very busy, doing all the widget repair they can handle. They are always booked a couple of weeks in advance. It might be because they are at the lower end of the widget repairing market. Their competitors charge $75 – $80/hour for the same service. The owner of the company pays his widget repairing employees $35/hour (the market rate), leaving him what he calculates as a $25/hour margin. However, at the end of every month, he just has a few dollars in the bank – not even enough to cut himself a check that would equate to 40 hours at minimum wage. So, what’s the problem? It could very well be that the owner is failing to take into account fixed costs.

Fixed costs are those incurred by the business just by being open. They wouldn’t change, even if the business serviced no customers or sold no products.

To illustrate with our fictitious organization, the owner of ABC Company pays each month –

Rent on the Shop $1000
Payments on Two Trucks $600
Tools $200
Truck Insurance $300
Liability Insurance $400
Utilities $400
Cell Phones $400
Accounting Service $150
Internet Service $100
Health Insurance $2500
Advertising $500
Total $6550

That’s $6550 to keep the doors open and the lights on (so to speak). If the two widget repairers get 40 billable hours per week every week, they log 344 hours per month (40 hours per week * 4.3 weeks in a month * two repairers). To cover these fixed costs shaves $19.04 off each hour that ABC company bills ($6550 / 344 hours = $19.04).

When the owner pays the widget repairers, variable costs kick in. Variable costs are those that are driven by volume of work or product produced – for instance, hourly wages, the cost of materials to build a product, shipping costs for a product, etc. In our example, the owner incurs variable costs of $35/hour in wages and an additional $2.67/hour to pay the employer share of Social Security and Medicare.

Here’s what’s left of the $60 the owner collects from customers –

$60.00   Customer rate
– $19.04   To cover overhead (fixed)
-$35.00   To the widget repairer (variable)
-$2.67   To cover employer share of Social Security and Medicare (variable)
3.29   Remaining margin

So, the $25.00 per hour margin the owner thought he was creating with his pricing and salary policy is really $3.29. Now it’s apparent why his competitors are in the $75-$80/hour range for the same service. It’s also apparent why he has no money left to pay himself at the end of the month.

You might be wondering if I’m exaggerating for purposes of this exercise. Unfortunately, the answer is no. I’ve worked with one client where the margin number was 0 and another where the number was in the single digits.

Let’s move on to this week’s exercise.

1.  For the last three months, go through your checkbook or copy of Quickbooks (or whatever your bookkeeping methodology is) and list each fixed expense.

Here’s a starter list (it’s by no means exhaustive). Go through your records and be thorough in finding every fixed expense.

Rent or loan repayment for your place of business

Vehicle payments or leases

Vehicle insurance

Business insurance (property, liability, E&O, etc)

Health insurance

Professional services (accounting, legal, consulting)

Technical services (website, internet, email, desktop support)

Communication (landline, cell phone)

Office supplies

Advertising

Administrative employees (those who would be paid even if no services or product were delivered)

Property Taxes

Total the numbers and calculate a monthly average for fixed expenses

2.  Calculate the opportunity to cover those fixed expenses – 

For service businesses –

For the last three months, calculate the number of hours for which you can collect money from customers (i.e. hourly charges that you can use to cover fixed costs) and calculate a monthly average.

For businesses that sell products (this calculation is trickier if you sell multiple products with different price points) –

For the last three months, calculate the number of units across which you can spread the fixed costs and calculate an average.

For retail businesses –

For the last three months, calculate the number of hours you are open, across which you can spread fixed costs and calculate a monthly average.

3.  Calculate the fixed cost to be covered each hour or by each unit –

Service – monthly fixed costs / monthly billable hours = fixed cost to be covered each hour

Products – monthly fixed costs / monthly units = fixed cost to be covered by each unit

Retail – monthly fixed costs / monthly hours open = fixed costs to be covered each hour

4.  Incorporate the fixed cost per hour/per unit into your pricing model.

For service businesses

variable cost per hour

+ fixed cost to be covered each hour

+ desired margin

= Customer price per hour of service

For businesses that sell products

Cost of good sold (labor + materials or purchase price)

+ fixed cost to be covered by each unit

+ desired margin

= Customer price per unit

 For retail businesses, the use of the number is a bit different

 Aggregate price of all goods sold in an hour

 – aggregate cost of goods sold in an hour

 = aggregate gross margin

Aggregate gross margin must be greater than fixed cost to be covered in an hour

Calculate this over the course time to determine which hours the retail establishment should be open.

5.  Check these calculations frequently. As volume (more hours or more units) goes up, fixed costs per hour or per unit go down, until you increase volume enough that you have to add fixed costs (hire another admin person, buy another truck, lease a bigger building). At that point the math changes again.

6.  I realize this week’s exercise can get complicated very quickly. If the simple examples in this exercise aren’t sophisticated enough for your business, consult your accounting or bookkeeping professional.

This exercise is incredibly important and could be the difference between staying around to serve customers for many years or being gone in just a few months.

If you have questions on this week’s challenge, contact me at 816-509-9838 or mchirveno@clearvision.consulting

Use the comments section below to benefit other business owners and managers by sharing insights you gained by working on this week’s challenge.