Once bitten by the entrepreneurship bug, many would-be small business owners are eager to visualize how their plans will unfold and are full of enthusiasm about charting their business growth. Fewer entrepreneurs sit down to mull over the other side of running their venture: the side that deals with costs and expenses. But like everything else, you’ll want to get both sides of the story before taking a risk and jumping in. Here is Kosmo’s contribution on the subject of costs, particularly as it applies to small business.
You’re ready to take the plunge and start a small business. Congratulations and best of luck with your new venture.
But before you get started, let’s have a talk about costs. Actually, cost accounting was one of my favorite subjects when I was trudging to class at Iowa State in the mid 1990s, so I’d love to go through a few examples here as a way to present the concepts.
Variable Costs: A Basic Example
Perhaps the easiest costs to understand are variable costs. Let’s say that you run a sandwich shop. A customer orders a ham and swiss sandwich on pretzel roll. (Yes, this happens to be my favorite sandwich — what a coincidence!). Once you make the sandwich, wrap it in paper, and hand it to the customer, you’ve incurred several variable costs:
- Ham – 60 cents
- Swiss Cheese – 15 cents
- Pretzel roll – 25 cents
- Paper to wrap sandwich – 4 cents
(Note: these costs are for the sake of illustration and are not intended to reflect actual costs of a sandwich.)
You’re spending $1.04 on every sandwich. Even if you have absolutely no other costs at all, you must charge at least $1.04 in order to break even. Charge anything less and you will lose money. These costs are variable — they are directly related to the number of sandwiches you sell.
Fixed Costs: A Simple Illustration
Fixed costs are the same regardless of how many sandwiches you sell. In the absolute sense, whether you sell one sandwich or sell a million, the cost would remain exactly the same.
However, very few costs are truly fixed. The few truly fixed costs that pop into my mind are related to starting the business. Applying for a trademark and registering your business with the state are a couple of things that are truly fixed. Trademarking “Digerati Delicatessen” will cost its owner (SVB) the same amount, regardless of how many sandwiches are sold.
Note: “Fixed” means that a cost doesn’t vary based on volume and doesn’t mean that it isn’t unchangeable. The cost may still change due to outside factors. For example, the state may decide to raise an annual fee. The fee would vary from one year to the next, but it’s still considered to be a fixed cost because the volume of sales isn’t driving the change.
We’ve covered fixed and variable costs, but there must be something else, right? Well, there’s more to say on the subject.
Fixed Within The Relevant Range
Fixed costs are basically split into two sub-types. The first type of fixed cost is the truly fixed cost mentioned above. These costs do exist, but they are pretty rare.
The far more common type of cost is the one that is fixed “within the relevant range”, to borrow a favorite phrase from my my professor. Whereas variable costs rise at a completely linear rate (one sandwich costs you $1.04, two sandwiches cost you $2.08) and the truly fixed costs remain exactly the same, the costs that are fixed within the relevant range (semi-fixed costs, if you prefer) increase in a stair step fashion.
The tricky thing here is that the range can vary widely. Some costs have such a narrow range that you can be tempted to look at them as variable costs, whereas others can have such a wide band that you can lull yourself into thinking that they are completely fixed.
Narrow Band Example: Labor
One of the costs on the narrow band is labor. Let’s say that you hire an employee. Between wages and benefits, the total cost of the employee is $13 per hour. If the sandwich shop is packed, the employee can make 45 sandwiches per hour. (Doesn’t sound very fast? Remember that they are running the whole operation — making the sandwiches and running the cash register). If you spread the cost across the 45 sandwiches, labor adds 29 cents to the cost of a sandwich.
But let’s say that it’s a rainy day and you have one customer in the span of an hour. How much does the labor cost add to the cost of the sandwich? $13. Ouch.
OK, that’s a pretty extreme example. Let’s move to a more realistic one. Your heroic employee needs help. She’s making sandwiches at a rate of 45 per hour, but has trouble keeping up. She sees people walking out the door instead of waiting. So you hire a new employee. Basically, you have two “steps” in your labor cost at this point:
- 0 – 45 sandwiches = $13 (1 employee)
- 46 – 90 sandwiches = $26 (2 employees)
What you want to happen now is to sell 90 sandwiches per hour. At a rate of 90 sandwiches per hour, labor would continue to add 29 cents to the cost of each sandwich. But let’s say that you only sell 48 sandwiches per hour. You’re selling only three more sandwiches than you were before, but it’s costing you $13 in labor to sell those extra three sandwiches. You’re going to see an increase in revenue, but a decrease in profits.
(OK, realistically, you’d give your employee a small raise and ask her to give 115% and make a few more sandwiches … but at some point, you’d reach her breaking point and have to hire a second person).
Wide Band Example: Rent
On the other end of the spectrum are costs such as rent. While rent appears to be a truly fixed cost, it really isn’t. How’s that? Mr. Furley wants his $1,500 per month, regardless of how many sandwiches you sell. That sounds pretty fixed.
The relevant range in this case is much larger, but it still does have a limit. Whether you sell one sandwich per month or a thousand, the rent is going to be the same. But what if you sell ten thousand, twenty thousand, or a hundred thousand? At some level, you hit the breaking point for your current location. You can’t squeeze in another customer without a shoehorn. You bid Furley adieu and move to a bigger location — at twice the cost.
Takeaways From Our Discussion
If you’re selling a product for less than the total of the variable costs, you can’t make up for this in volume — you’ll just lose more money. If you’re selling crisp, authentic, $1 bills for 90 cents, you can’t make up for this in volume.
Your business will be the most profitable when you are near the maximum edge of the relevant range for fixed costs. It’s far more profitable to sell 45 sandwiches than 46, since stepping into the 46 to 90 range means hiring a new employee. Likewise, it’s more profitable to rent a smaller location and have it filled to 95% capacity than to have a location twice the size, but only filled to 55% capacity.
So that’s what we have for now. This is a basic introduction to cost accounting, which entrepreneurs should keep in mind when making decisions for their businesses.
Copyright © 2012 The Digerati Life. All Rights Reserved.