As a business owner, understanding the difference between variable vs fixed costs is essential to making sound decisions about your company’s growth. Knowing how to manage each type of cost in order to maximize gross profit margins and net income can be the key to long-term success.
When you understand the difference between variable vs fixed costs you are better able to determine how to optimize your budget when growing your company. Not only that but understanding the difference between variable vs fixed costs will also help you maintain a healthy gross profit margin as well as a better bottom line net income.
Maximum Possibilities understands the difference between variable and fixed costs. We are here to guide you in understanding how they impact your gross profit and net income. Let’s look at the difference and how best to operate your business for increasing profits during business growth and obtaining better financial outcomes in a possible business transition.
Variable vs Fixed Costs
Variable costs are those that change depending on production levels or sales volume. For example, the cost of raw materials or labor can vary based on the number of products being produced or sold.
On the other hand, fixed costs are those that remain constant regardless of production levels or sales volume. Examples include rent, utilities, insurance premiums, and administrative salaries.
Maintaining Variable Cost Ratios Compared to Sales
Variable costs are those associated with producing your goods or services—including raw materials and labor. These costs can change according to production levels. It’s important to keep an eye on the ratio of variable costs compared to total sales. When costs get too high, they eat away at your gross profit margins.
It’s important to keep track of what percentage of total sales goes towards variable costs such as materials or labor to ensure maximum profitability per sale item sold. One way to do this is by using a simple equation: [(Total Variable Cost/Total Revenue) X 100 = % Variable Cost]. If you find that your percentage of variable cost is too high considering projected profits from each sale item produced, then adjustments need to be made. This variable cost percentage of sales can be benchmarked among similar businesses.
Two areas where variable cost ratios can be lowered are by reducing material cost per item produced or increasing sale prices accordingly. If your material cost prices begin to increase it may be time to find new suppliers who offer better prices on materials needed for production. Or you can renegotiate prices with vendors with whom you have long-standing relationships.
Another option is offering incentives such as discounts to customers or free shipping on orders over a certain amount. This method allows you to increase sales volumes without increasing your overall cost of production too much.
Raising your sales price may only be feasible if market conditions are favorable to such an action. For example, many product categories were affected by the pandemic due to supply chain issues. Passing that cost through to the customer may be accepted, especially on non-essential items. But, for essential goods and services, passing the cost through to the customer may be seen as price gouging and have a greater negative effect on your business than any slight cost variable.
It is essential, when dealing with variable costs, to take into consideration the perceived value and any potential negative consequences that increasing sales prices may have.
Improving Gross Profit Margins
There are several steps you can take to improve gross profit margins without compromising quality or customer service.
- Negotiate better terms with vendors.
- Focus on increasing efficiency through process optimization.
- Automate where possible so that fewer people are needed for production tasks.
- Look into alternative financing options so that cash flow remains healthy even when profits are not as high as desired.
With these tips in mind, you can make sure that your company’s financial future remains bright!
Maintaining Fixed Costs
When it comes to maintaining fixed costs, it’s important to look for ways to eliminate non-value-added expenses without sacrificing quality or customer service. One way to accomplish this is to shop around for better rates on supplies whenever possible.
It’s also helpful to review contracts regularly. Do this to make sure you’re getting the best deal possible for services such as marketing or IT support.
Another method to maintain and lower fixed costs is by conducting an annual review of pricing plans for reoccurring services. Services like utilities, phone, and internet often have an annual rate increase. If you call your provider, it is possible to reduce the amount of increase each year.
Growing Your Company While Optimizing Fixed Costs
When growing your company, it’s important to think strategically about increasing staff size and overhead expenses such as rent or utilities. Consider whether an increase in staff size would be necessary before making any hiring decisions. Often delegating additional work responsibilities among existing team members can help save money while still achieving desired growth goals.
Since the pandemic virtual or hybrid workspaces have become popular and “the new normal.” Instead of investing in additional office space right away, consider leasing co-working spaces on an as-needed basis. Or, explore virtual office solutions.
Another option to consider is investing in technology that can help streamline processes and reduce manual labor requirements. Investing in automation can help save money while still providing the same level of quality service customers expect.
Alternatively, often the investment in support infrastructure is not added in advance of rapid growth. The result is stressed employees and broken, inefficient processes. Fixed costs should be considered as investments and may need to be made in anticipation of growth. A robust forecasting process reduces the risk to the organization of making investments in advance of growth.
In conclusion, understanding the difference between variable vs fixed costs will help businesses make more informed decisions. Understanding how variable vs fixed costs affect gross profit margins and net income is critical if you want your business to grow sustainably and successfully over time.
With this knowledge, you can optimize your spending while still achieving desired growth objectives without sacrificing quality along the way. Additionally, tracking what percentage of total sales goes towards variable costs allows your business to stay ahead of potential losses due to their rising expenses while ensuring you remain profitable with each product sold!
When business owners consider these steps when managing their finances, they should be able to see steady growth over time with improved bottom line results!
Let Maximum Possibilities Help
Let’s discuss your company’s variable and fixed costs and how they are affecting your business’ profitability or valuation. Schedule a call today and let Maximum Possibilities help you.