Fixed. Quite the word, isn’t it?
What images does it bring up for you?
For me, it brings up images of unchangeable, immovable, solid, stationary, set.
Fixed costs are necessary. Or at least you thought they were necessary when you incurred them.
And why did you incur them?
To attain a particular result in your business. To achieve something perceived as critically important in your business.
A New Definition of Fixed Costs
A bundle of Fixed Costs are costs of overhead needed to achieve a particular sales volume in your business.
The key is the last part. They are designed to attain a particular level of sales volume.
Unlinked to sales volume, then what exactly are they for?
Unlinked to sales volume, fixed costs have no relevance. They can only be incurred for three reasons:
- Ego gratification. For example, management loves a big, fancy office. The big, fancy office is not needed for sales volume per se.
- You incurred the cost in the past. You no longer need it; you are just trapped inside a fixed agreement like a lease.
- You have not paid any attention to your fixed costs. They just creeped forward on you unawares.
Here is a remarkably simple, personal example of “unlinked to a result” fixed costs.
Imagine you have a goal – to get fit.
You join a gym. You go for a while. Then you buy a home gym. You stop going to the gym. You continue to pay. (You are locked into a contract. You are just not thinking about it).
The fixed gym membership fee is now “unlinked” to your goal. It is an irrelevant cost.
A few of these and you have massive, fixed cost creep, and diminished or disconnected results.
Re-Thinking Your Bundle of Fixed Costs
On your Profit and Loss Statement there are three main categories.
Sales, Cost of Goods Sold, and Overhead (comprised of mostly fixed costs).
Sales less Cost of Goods equals your Gross Profit.
Your Gross Profit must cover your Fixed Costs plus your expected or desired Net Profit.
Start to think of your business, or any business, like this….
Take your Gross Profit percentage and divide it by your total Overhead (Fixed Costs) plus your desired profit and you will arrive at your required sales volume.
Now, here is the switch I want you to make in your thinking.
Think of your bundle (or group) of Fixed Costs as related to the capacity of volume your business must attain to break even and make a profit.
An Analogy
To make it clearer – think of this bundle of Fixed Costs like a machine.
You lease a machine. That is your fixed cost. The machine has a fixed, maximum capacity. It can produce so many widgets and that is it. You can determine what that is by the output per hour, as a simplified example.
Now it gets a bit tricky. Unlike a machine, your fixed costs are comprised of a group of expenses related to your sales volume capacity.
Some of those expenses will be non-contributors. They are no longer value contributors to your sales volume.
A Step-By Step Breakdown
Let us say you have $50,000 in monthly fixed costs.
Your Gross Profit Margin is 40%.
You desire a Net Profit of $20,000 per month.
Take the $50,000 and add the Planned Net Profit. You get $70,000 ($50,000 plus $20,000).
Divide that by the Gross Profit Margin of 40% and you have a required Sales Volume of $175,000 ($70,000/40% = $175,000).
Here is a simple re-work:
Sales $175,000
Cost of Goods Sold (60%) (105,000)
Gross Margin – 40% 70,000
Fixed Costs 50,000
Net Profit $20,000
You sell one product at $10 each. Your break-even sales volume is 17,500 units ($175,000/$10 per unit) = 17,500 units).
Okay, so now you can think of your Fixed Costs as having to produce (like a machine) 17,500 units.
Three Crucial Questions
Now in examining your Fixed Costs bundle with this latest information related to capacity, you must ask yourself these questions:
- Is my business capable of producing 17,500 units, with this bundle of costs?
- Is my business not capable of producing 17,500 units with this particular bundle of costs?
- Is my business capable of producing 17,500 units, yet could do so much more efficiently?
Now, go through each expense and ask these two questions:
- Is this cost necessary to produce my required volume of 17,500 units? If not, kill it if possible.
- Is this cost necessary, yet too high? If yes, try to renegotiate contracts or find new suppliers with less cost for this expense.
Convert Fixed Expenses to Variable
The best approach for managing capacity and for growth is convert Fixed Costs to Variable Costs.
How to do that?
Ask more questions:
- Do you need an office at all? Can your team work from home as effectively? Can you downsize your space? Or sub-lease?
- Can you convert employees (usually your biggest expense) to part-time employees? Can you outsource the work done by employees? That would convert that large expense to a variable one.
- Can telephone contracts be renegotiated?
- Can you partner with suppliers to pay them a volume type incentive rather than a fixed fee?
In Conclusion
Finally, remember to review your Fixed Costs on a frequent basis, even monthly.
A closing example is looking at software costs. These can get sticky. Often, we pay for needed software as a service. We stop using it, and we forget to cancel. So, it is a good idea to at least review these types of sticky costs monthly.
Thank you for reading…