In conquering your business numbers, understanding what accountants and potential investors are asking you can certainly help build your confidence. The concepts behind the words can also give you insights in to your business that will help it grown and succeed.
Two terms you may have heard are fixed costs and variable costs. Understanding these two terms is important in setting your prices and budgets. So what are they?
The names are pretty self-explanatory. Variable costs are those costs that vary with your levels of production and sales. If you are making cakes then the amount of flour you will need to buy will depend on how many cakes you make as will the amount of boxes you need.
Fixed costs are those costs that don’t vary with the level of production. Classic examples include kitchen rent, web hosting and insurance on equipment. Of course no costs are truly fixed, as you grow you are going to get to the point where you may need a bigger kitchen, more powerful web hosting and more insurance.
But why does it matter knowing which is which?
Keep fixed costs to a minimum
In very broad terms, you want to keep fixed costs to a minimum especially when you are first starting out so you aren’t incurring costs while you are waiting for income to come in. Understanding your cost structure is the first step in doing this. Of course you don’t want to go overboard on minimizing fixed costs. If you try and squish people into a very small kitchen then you may create more inefficiencies than the savings you make. Casual staff may work initially but if you are getting a high turnover because of job insecurity then the cost of retraining staff may well make it worthwhile offering a great staff member something more permanent.Understand your cost structure. What is fixed and what is variable? #business #accounting Click To Tweet
Investors may want to know
Investors will be interested in finding out about your cost structures. They will want to know how much of your cost structure is flexible, that is what are variable costs and how much is fixed, your ratio of fixed to variable costs. To calculate this ratio you take your fixed costs for a set period (say the past year) and divide by the variable costs for the same year. They may also want to know how much of your revenue is spent on fixed costs.
The amount of fixed costs expected will vary depending on which sector of the food industry you are in. If you are working with investors then there are a number of (paid) sources out there that can tell you what the ratios are for your sector. Libraries may have relevant information for free and banks are often a good source of free advice. And your industry association or fellow business owners may be willing to share. You may be surprised at how generous others can be with sharing their knowledge.
The other way you can categorize costs is into direct and overhead costs but I will leave that for another day.