Recent supply chain and energy cost increases have punched holes in the budgets of businesses around the world. The companies most likely to be coping well are those that anticipated the potential for variability and took steps to minimize its impact on their bottom line. Let’s look at the ways variable costs can impact your business, and some ways you can proactively address them going forward.
One thing to keep in mind as you read more about the difference between fixed and variable cost is that really all costs are variable. The difference is the time, timing, and/or effort to change a fixed cost. As much as possible in uncertain times you want to minimize the fixed nature of your fixed costs as much as possible and always keep a creative eye on how can you reduce those costs – do not just assume they are the same every month.
FIXED COSTS VS. VARIABLE COSTS
Fixed costs are costs that shouldn’t change month-to-month. Your office rent, for example, is fixed for the year. The annual salaries you pay are fixed. Your insurance costs should be fixed. Expenses like these are simple to budget for because you know their impact on your cash flow with certainty.
Variable costs, on the other hand, are unpredictable, and any significant increase in them can be an uncomfortable surprise. There are three types of variable costs to consider:
Costs based solely on increases or decreases in sales or production. These won’t be covered in this post because they shouldn’t be a surprise, per se. If you are pricing your goods correctly and maintaining your inventory efficiently, any extra costs should be covered by increasing profits.
Costs based on changes to product inputs. These increases to your cost of goods sold can be an unpleasant surprise and have a big impact on your budget. If your raw materials costs suddenly spike, or your transportation costs increase due to rising gas prices, your cash flow situation can change significantly.
Other operating expenses. These are things like electricity or natural gas, office supplies, and services you pay for by the hour or by usage. Again, if increases are due to increased production, you should be covered by rising profits. But if not, then increases in these costs can really affect your business.
STEPS TO CONSIDER TO REDUCE THE IMPACT OF VARIABLE COSTS
There is no way to fully eliminate variable costs, but there are ways to minimize uncertainty and limit their potential impact on your business. For example:
Look for opportunities to fix costs at lower rates. Oil refiners and farmers do this all the time via fixed price contracts, and you may be able to as well. Your suppliers may be willing to sell you materials for a fixed price for fixed period, and utilities like electric companies will often offer annual contracts in lieu of variable monthly pricing. Note that you may ultimately pay a bit more, but the ability to plan your budget and protect your cash flow is often worth it. During the height of the pandemic a number of businesses renegotiated rent costs to be able to survey as well.
Be more efficient. Are your HVAC systems old and inefficient? Consider having them improved or replaced. Are gas prices affecting your transportation costs? Look at other forms of transportation or make use of virtual services to carry out business tasks where possible.
Look at your past variable costs. If you have been in business for a while, look at what your average cost variability has been. You might find that, on an annual basis, it hasn’t fluctuated that much. And if it has, use the highest three- or five-year period for budgeting purposes. Your accounting department or bookkeeper should be able to provide these numbers.
Budget for the highest expected costs – then add a little more. It is no fun to see your budget constrained in other areas as you plan for costs you may not incur, but a surprise can really hamstring your business, so consider adding three to five percent more to your variable costs budget, just in case.
Create a savings account specifically for variable costs. If you have money to set aside now, do so. If not, plan to set aside a certain amount over the next few years. This doesn’t have to be a permanent annual contribution, since you will likely want to put extra cash toward growing your business. Just build up the account to a point that it could cover a big, unexpected increase in costs.
Get a credit line before you need one. The time to get a credit line is before you need it, when your credit is good and you have time to shop for the best rate. Don’t wait until you are facing an emergency due to unexpected costs and have to scramble to get a loan.
As we’ve seen in the current business environment, increases in variable costs can never be fully anticipated. But by taking some proactive steps, you can insulate your business from cost surprises and be able to ride out any rough patches.