Your company’s income statement, particularly if you manufacture products, has two kinds of costs on it: fixed and variable.
Before you make big decisions affecting production, it’s crucial to understand these costs and what they mean for your business. In this post, we break down the difference, why both are important to your bottom line and how to handle both.
Fixed Costs: Not Tied to Production
No matter how many products you make, certain business costs will always exist. Your rent and loan payments, for example, stay the same whether you make new products or not.
These fixed costs can change from time to time, such as when your landlord raises the rent. They do not, however, change just because you increase or decrease your level of production.
Because total fixed costs stay the same no matter how much you produce, they usually don’t figure into your production decisions. When you’re deciding whether it’s worth it to make more products, your decision revolves around variable costs.
Variable Costs: Fluctuate According to How Much You Produce
If you’re a smartphone manufacturer, certain costs will increase if you decide to make more smartphones. These costs might include:
- Extra component parts for the new phones
- Increased labor costs
- Added energy costs for running machines longer
- Additional costs for transporting more phones to distribution centers or stores
Marginal Cost and Economies of Scale
Marginal cost is the added cost of producing one additional smartphone. Suppose you’re producing 100 smartphones, and you have $2,000 worth of supplies on-hand. Your current supplies cost per phone is $20.
If you can produce one additional smartphone without buying new supplies, your supplies cost drops to $2,000/101, or $19.80. In fact, let’s imagine you can produce 150 smartphones without added supplies, new machines or hiring someone else.
You’ve just created an economy of scale, in which producing more actually drops your cost per unit to $2,000/150, or $13.33. If you sell each smartphone for $199, you now make a profit of $185.67 per phone ($199 - $13.33) instead of making a profit of $179 per phone ($199 - $20) if you only made 100 phones.
Producing the extra 50 phones, all things being equal, is a good business decision. However, producing 151 phones means you have to make a new supplies order, hire a new worker, and add a new machine. Therefore, you don’t have a compelling reason to manufacture that 151st phone.
Related Article: Made in the U.S.A: Is Outsourcing Dead?
When to Take Out a Loan to Produce More
In certain cases, taking out some capital to finance a higher production run—and to create a higher economy of scale—is a smart way to increase your profits. You get certain tax advantages for carrying debt on your balance sheet, you increase your production and you expand your customer base.
You may only need to take out a short-term loan to get enough capital instead of being saddled with a loan for the next five years, which can help you carefully budget for your increased production numbers.
You can get loans from traditional banks if you have an established credit line and time to wait. For faster decisions, you can get a fast business loan from an online lender to ramp up production quickly. Before taking out a loan, think through the pros and cons of increasing production:
- Bigger profits per unit
- Ability to add equipment to increase long-term production capacity
- More units produced, meaning faster filling of customer orders
- Loan interest deducted from company tax return
- Short-term inconveniences of ramping up capacity, including training new workers, installing equipment, and building new plants
- Interest on your debt is a fixed cost which means more pressure to make profits
- Risk of having an oversupply if you overestimate demand, customer orders fall through, or the economy tanks
- Added marginal costs of storing and transporting more inventory
You want to ramp production enough to create a new economy of scale, but you don’t want to produce so much that you’re not turning over inventory quickly. Examining your marginal costs as well as your sales forecasts can help you find your production sweet spot.
Related Article: Before the Business Loan: Questions That Must Be Asked
Many businesses fail because they become too dependent on a single customer who bails on them. If you’re ramping up production for a single customer, protect yourself before taking out a big loan:
- Ask for a deposit and progress payments. Avoid manufacturing everything, getting to the transaction, and hearing, “We don’t need these after all.” When you collect a deposit and progress payments, you at least have some money in the bank if your customer falls through.
- Sign a contract. Get a signed agreement stating what your customer has ordered, how much your customer will pay, and when the payment is due.
Once you’ve increased capacity, work hard to find other customers in addition to the big fish you landed. If your big customer moves elsewhere later, you won’t find yourself completely leveraged and without any options.
Although both fixed and variable costs are important, variable costs are often easier to control, and they play a bigger role in production decisions. Production increases aren’t a decision you should leave to a bookkeeper. Talk everything through with your CPA before you proceed.