Fixed Costs
Fixed costs include expenses that must be paid regardless of whether any units are produced or not. They remain constant over a specific time frame or production range, and examples include:
– Rent for the workspace (or mortgage) over the contract period
– Initial loan payments (if you financed the startup costs)
– Property taxes
– Insurance
– Vehicle leases (or loan payments if the vehicle was purchased)
– Equipment (machines, tools, computers, etc.)
– Salaries (if employees are on a fixed salary)
– Utilities
– Accounting fees
Calculating fixed costs is straightforward for established businesses, but new companies must research to gather the most accurate numbers available.
Variable Costs
Unit costs vary depending on the number of products produced and other factors. For instance, the cost of the materials needed and the labor used in producing the units may not always be the same. Examples of variable costs include:
– Employee wages on a commission basis (like sales representatives) or contractors
– Utility usage – electricity, gas, water – that increases with activity
– Raw materials
– Shipping
– Advertising (can be fixed or variable)
– Equipment repairs
– Sales tools such as credit card processing fees
Sample Calculation
Assume your fixed costs for producing 30,000 units are $30,000 annually.
Your variable costs are $2.20 for materials, $4 for labor, and $0.80 for overhead, totaling $7.
If you choose a selling price of $12 per unit, then:
$30,000 / ($12 – $7) = 6,000 units.
This means that selling 6,000 units at $12 each covers your costs of $30,000. Each unit sold after 6,000 generates a profit of $5. A breakdown of the sample leading to this calculation might look like this:
Using Break-even Calculations
Break-even analysis allows you to apply various scenarios to your break-even point and potentially increase profits. Some reasons for calculating the analysis include:
– Increasing the selling price: Continuing with the example of units priced at $12, raising the selling price by one dollar reduces the number of units you need to sell by 1,000 based on a new calculation: $30,000 / ($13 – $7) = 5,000. However, increasing the selling price is often not an option in a highly competitive environment.
– Reducing fixed costs: If you can reduce fixed costs by $5,000, you would also lower the break-even point to 5,000 units sold. Reducing rent and salaries are common ways to decrease fixed costs for businesses, as well as relocating to areas with lower business taxes or lower utility costs.
– Reducing variable costs: Reducing variable costs by one dollar would also lower the break-even point by 5,000 units. Variable costs are often reduced by cutting material or labor costs. For example, a builder might source wood from a supplier at a lower cost or leverage equipment and/or technology for automated production.
– Increasing sales: Assuming the break-even point for units is 6,000, increasing the number of units sold to 10,000 would raise profits by $20,000 (4,000 units at $5 each). This calculation can be used when considering the benefits of advertising. Increasing your advertising budget by $5,000 annually would raise your fixed costs to $35,000 and the break-even point to 7,000. If an advertising campaign of this nature raised your unit sales from 6,000 to more than 7,000, it would be considered successful.
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