Understanding Cost Drivers in a Small Business

Textbooks abound on the subject of costs in a small business. Most will make your eyes glaze over with boredom. However, a little knowledge of your costs and cost drivers will help you understand your business better and plan for the future.

One way of looking at the costs of your business is by defining them as either fixed or variable. A fixed cost will not change regardless of your sales volumes. Examples would be rent, heat, salaries, or business taxes. Of course, if your sales were to quadruple overnight, you might need a larger warehouse etc. but, for simplification, these costs generally do not change when your sales increase or decrease. A variable cost, on the other hand, changes in direct proportion to your sales volume. Some examples are: sales commissions, hard drives if you sell computers, or sugar if you sell cotton candy.

So why do we care what kind of expenses we have? For the simple reason that the fixed costs have to be covered somehow even if you don't sell a single thing! If your business is laden with fixed costs, you run a greater chance of business failure.

We'll use Joe's Plumbing as an example. Joe works out of his house so he doesn't have to worry about rent. He does have other fixed costs though; the lease payments on his truck, the big display ad in the yellow pages, and the interest on the loan he has taken out with the bank. Joe must pay these things regardless of whether his business is hopping or slow. On the other hand, the plumbing supplies that Joe uses in his business represent a variable cost. He only buys them if he needs them for a job. He won't lose money on variable costs because he will get paid for that job.

Fixed costs can sink a business. Many startup businesses "invest" in fancy office space, big advertising campaigns, and lots of staff. If the sales don't start as quickly as planned or reach the levels intended, however, a business can find itself in a serious cash crunch.

What can you do about it? First, get acquainted with your income statement. Go through with a marker and mark your fixed costs with an "F" and your variable costs with a "V". Now, concentrate on your variable costs for a minute. What is your gross profit from selling one unit of your product? For example, if you sell a computer for $950, your gross profit calculation might look something like this:

Sales price $950

CPU 125

Hard drive 310

Motherboard 150

Other parts 110

Direct labor 140

______

Gross profit 115

That means that you get $115 for every computer that you sell after you have paid for your variable costs.

Now, let's look at your fixed costs. A fixed cost summary for a year might look something like this:

Store rent $12,000

Staff 29,750

Yellow Pages ad 3,300

Delivery truck-operating costs 1,959

______

Total 47,009

So, how many computers do you have to sell in a year to cover your fixed costs, or to break even?

47,009/115 = 409

You will have to sell at least 409 computers to keep the doors open. And that doesn't include any profit.

If you decrease your fixed costs by 10%, you would only need to sell 368 computers to break even. As you can see, fixed costs can have a substantial impact on a business.

Now, use your own financial statements and run a breakeven analysis. If you run a service business, breakeven still has the same meaning but looks a little different. Instead of units of a product you are selling, it is units of your time. For example, if you are a family counselor, you would bill yourself out at a certain rate, say $75 per hour. You would have few, if any, variable costs, so the entire $75 per hour can cover fixed expenses. If your fixed expenses are $20,000, how many hours would you need to bill out in a year?

$20,000/$75 = 266 hours

You would need to bill out 266 hours to cover your fixed costs of operation. As there are about 1,900 workable hours in a year, this seems reasonable. However, if your required number of hours works out to 2,500, either your billing rate is too low or your fixed costs are too high.

Understanding the nature of the costs in your business is a great start to planning your business growth.