Knowing the relationship between revenue and expenses is the key to understanding your business's profitability. How expenses change in relation to changes in revenue determines the cost structure of your business.
The cost structure is stated in terms of fixed and variable expenses. It’s necessary to classify your expenses as either fixed or variable if you want to understand the profitability of your business.
Classifying an expense as fixed or variable is determined by how a particular expense fluctuates with sales volume. If an expense increases when sales increase, then it’s a variable expense. If an expense remains constant when sales increase, then it’s a fixed expense. Fixed costs plus variable costs equal total costs.
Examples of fixed expenses are rent, overhead, insurance, dues, advertising and administrative salaries. These costs remain the same whether sales increase or decrease. Only when sales increase dramatically, do these costs increase. For purposes of this article, we will assume that fixed costs always remain constant throughout a change in sales.
Variable expenses include raw materials, inventory, production costs, sales commissions and shipping costs. These costs fluctuate in direct relation to sales volume. If sales increase, then variable costs increase. If sales decrease, then variable costs also decrease.
Relationship Between Sales and Expenses
If you want to know how your expenses fluctuate with sales volume, then you must understand unit costs. Because fixed costs don’t change as sales volume changes, the fixed cost per unit changes. For example, ABC Chairs has monthly fixed costs of $2,000 to produce chairs. The $2,000 stays the same whether ABC Chairs produces 10 chairs, 100 chairs or 500 chairs.
This chart illustrates how fixed costs per unit decrease as sales increase.
Because variable expenses change directly as sales volume changes, the variable cost per unit remains the same. For example, if ABC Chairs has variable costs of $500, $5,000 and $25,000 to produce 10 chairs, 100 chairs and 500 chairs, respectively, then the variable cost per unit remains the same.
This chart illustrates how variable costs per unit remain the same as sales increase.
Fixed and Variable Expenses Determine Profitability
Measuring expenses as either fixed or variable is commonly used for budgeting and planning purposes. Since net profit is the difference between sales and expenses, knowing how fixed and variable costs behave relative to sales is a must. If you know how costs fluctuate with sales, then you can determine your bottom line at each level of sales volume.
Profit analysis chart
On the graph, you can see the relationships working as previously described. As sales increase, so do the variable expenses. Fixed costs remain the same throughout every level of sales volume. Since profit is the difference between sales and total expenses, profit increases as sales increase.
Profit always increases directly relative to sales, as long as variable costs per unit doesn't exceed sales per unit. If variable costs per unit exceeds sales per unit, then you have a major cost structure problem. Your business is not viable and will never make a profit.
Another thing to notice is what happens in the graph at a volume of 25 units. At 25 units, profit equals zero. This is called the break-even point. Every business owner should know the sales volume at which the break-even point occurs.
At break-even, sales equals the total of fixed and variable costs. At every sales point above the break-even point, profit increases. At every point below break-even, profit decreases.
Product Line, Departmental or Business-Level Analysis
You can apply a profitability analysis to your overall business or to smaller segments of your business. For instance, it's common to run a profitability analysis using fixed and variable costs on a new product line. This gives you the information necessary to estimate profits at different sales volumes. You can determine at what sales level that you'll break-even.
You can also analyze the fixed and variable cost structure of various departments within your company to determine which departments are most profitable. You may decide to divest the least profitable areas of your business and allocate more resources into the more profitable areas.
Knowing the fixed and variable cost structure within your business gives you the necessary know-how to determine your annual budget and goals. You'll know how to focus on sales volumes within your company. Sales personnel will be alerted to areas where sales efforts are needed. Underperfoming departments can know when it may be necessary to cut fixed costs, such as personnel or overhead.
Knowing the relationship between your sales and expenses is key to running a successful business. The goal of any business is to cover fixed costs and profit from increased sales volume. By understanding the cost structure of fixed and variable costs you can see and maintain your company's profitability.