Fixed Costs verse Variable Costs – Products
Let me start by saying this is an important concept. You need it to build all financial models. There are few concepts more important than this to all new businesses. If you don’t get this, then give up on starting your own business.
OK, so some of this may be hyperbole. Let’s get this straight, fixed and variable costs are important things to understand. But what frustrates me is that they are pitched as black or white, zero or one, on or off. They aren’t. But too many people teaching others almost seem to use this concept as a way to show off their knowledge and talk down to new people. I don’t like that at all. First, because it’s not that simple. Second, because I don’t think any teacher should talk down to those they are teaching.
I am here to teach. I know a lot of entrepreneurial concepts and financial modeling, but entrepreneurs know their business way better than I do. So I might know something they don’t, or you don’t if you’re reading this, but then if you are starting your own business, you know something I don’t know I’m sure. You wouldn’t let me bake your wedding cake, you really shouldn’t let me do your taxes, and when it comes to landscaping I am sure you have better options than me.
So to come at this a different way I’ll use some of the traditional concepts as they are taught, then show you some gray areas. Later on, I’ll get all excited showing you how to model those gray areas, but I’ll wait. I want you to read these posts and get to know me before I expose how much I’m a dork and love financial models. But the great part about understanding the gray areas is I’ll also teach you that just because your initial model doesn’t look like what you would like, doesn’t mean you need to abandon your dream of being an entrepreneur, it usually just means you need to pivot and lean into a few of the gray areas. Also, for now, let’s discuss this for products only, we’ll do break even for things like services in the next post.
To start with, let’s get simple. Most of us have cars or at least understand what it’s like to own a car. You have a car payment, insurance, gas, and oil changes. So for this example, the car payment is a fixed cost. Every month you owe that payment no matter how many miles you drive. Gas is a variable cost. The more miles you drive, the more gas you use. Simple, right?
So in traditional teaching they would say insurance is a fixed cost. You pay your insurance the same amount every month or quarter, or however often you pay your insurance. We’ll use moth for this example. But when was the last time you applied for a new car insurance premium? They ask you how many miles you drive your car, right? The more you drive, the higher the rate. The less you drive, the lower your rate. So it is a set cost every month once you sign the contract, but it can change over time and it will change based upon usage or in this case our “production” is miles driven.
Now let’s look at oil changes. That’s a variable cost right? If our car needs an oil change every 7500 miles, then the more we drive the more oil changes we need, right?
Let’s pause while I tell you to read your owners manual for your car. I know I sound like an even bigger nerd than usual, but hear me out. The manual tells you not only how often the manufacturer suggests you get an oil change, which varies car by car, even within the same brand. The Toyota Camery and the Toyota Civic maybe have different schedules, in fact, the Civic Type R might have a different schedule than the base model. So it is good to know. Plus it tells you things like recommended tires pressure. I’ve also never read an owners manual where I didn’t learn a cool trick about the car that I didn’t know before, like if you push this button something else shows up somewhere else. You don’t need to read every word but skim it at least and tell me if you don’t find something interesting.
Back to fixed and variable costs. Oil changes seem very much a variable cost, the more you drive, the more often you need an oil change. But not all oil changes are the same, not is all driving them same. Lots of stops and starts, say delivering things? That needs more frequent changes than recommended. Synthetic verse conventional motor oil? Synthetic costs more but then you can often change the oil less often. Again, not as simple as we think.
So what do we do? How do I teach you?
Two words: Ceteric Paribus.
Ceteris Paribus is Latin for “other things being equal or held constant.”
So what we need to do is freeze in time and make a model based upon where you are now. So if you are starting a cake making business, and do not have the need or want to move to a commercial kitchen, let’s model as if you are working out of your house, and that is now a fixed cost. We understand that as you grow, we can move to a commercial kitchen, but for now, let’s model and think of rent as your own kitchen.
So fixed costs are, the more you cook, the more cost of the ingredients, the more electricity, and the more cost of delivery. Should you bill yourself for use of your own kitchen? Yes! Will we talk about that later? You know it, so for now, let’s say you use your own kitchen and bill your company $100 a month, for ease of math. Now that is a fixed cost.
Now let’s say you need insurance and you bought a professional mixer that you make payments on. So Insurance is $10 a month and payments on the oven are $5 a month. If we total this, we have a total monthly outlay of $115.
For variable costs, we have the cost of the cake ingredients. Let’s say they cost us $15 to make. We then sell them for $20 a cake. That means we make $5 a cake right? $20 for the sale price minus the $15 for the ingredients means $5 of profit. Well, no. To break even we still need to pay off that monthly fixed cost of $115.
So this means that for every cake we sell, there is $5 to contribute toward those fixed costs, called shockingly enough, the contribution margin. If our fixed costs are $115, then we divide that by the amount of excess revenue generated by each cake ($5) then we get 23. That means to break even, to pay all of the bills in this very simple model, we need to sell 23 cakes.
To come at it another way, let’s say we start every month at negative $115 We paid our fixed costs on the first and now have a negative balance. If we sell one cake that month, our revenue is $20. Then we subtract the $15 for the cost of goods sold (COGS in accounting terms, one of my favorite acronyms) and we have $5. Now we can take that $5 and apply it to our negative balance, so now we have a negative balance of $110. We would need to repeat this 22 more times to pay off the negative balance and…break even. Then any cake after 23, starts to generate profit. So if you sold 25 cakes in a month, you’d have a profit of $10, the first 23 going to pay off the fixed costs, and the last two creating excess cash.
I’ll add a slide deck to this post that I made for the local non-profit I volunteer for (The Community Investment Council https://cicville.org/). This helps give a visual component to what I am saying above.
Now for our DIY tip of the week. Since we talked about oil changes earlier, I thought I’d talk about them here as well since most of us need to get an oil change at some time. Changing the oil on my car was actually the first thing I learned to do on my own. In theory it is a simple concept. Drain your oil, remove your oil filter, put back on a new oil filter, and replace the oil. Executing all of that can be a bit more challenging than that but overall, it is straightforward if nothing else.
ChrisFix on youtube has a decent starter video (youtube.com/watch?v=O1hF25Cowv8) though I don’t recommend you use the “drive the car onto the curb” method of jacking up your car. Ramps make it easy but if you don’t want to buy ramps and a set of jack stands with a jack, I recommend you get the jack stands and jack as they will provide more flexibility for doing things like changing brakes.
You can also take your car in and let someone else change your oil. It’s quick and easy plus you get less dirty. If you can work on your business while waiting for your car, it actually might be more economical. How? Well, if you can generate more than the cost of the oil change in value to your company in the time it takes to wait for your car, you generated more income than you spent. If an oil change costs $75 at an oil change shop and take 30 minutes to get done, and during that time you reply to emails, those replies generate $100 in revenue, you’re $25 ahead.
No matter which way you go, there are a few questions to ask yourself. First do you need synthetic oil? To understand the difference try Engineering Explained, one of my favorite youtube channels, specifically youtube.com/watch?v=lo7rrex0IsE . Basically though, if you want to go longer between changes or are hard on your car, I’m looking at you entrepreneurs that do deliveries and have a lot of stop and start driving, then synthetic is the way to go.
Filters are much the same. A more expensive filter is usually a better filter, which will help keep your oil cleaner, longer. I know oil changes are boring but as I mentioned in an earlier post, sometimes the most important stuff is the most boring. It is the basics, the building blocks, so while boring we should not ignore it, nor put it off. While in the short—term it if fine, over the long haul not doing the basics, the maintenance, will cost you more overall. I’d rather not be able to deliver product for an hour because I’m either changing the oil myself or getting someone else to it, than I would lose a week or more because the whole engine needs to be replace.