As the old saying goes, you have to spend money to make money. The challenge for business owners managing their business costs is to make sure they’re spending money in the right way. 

Business costs encompass all the expenses of running a business, from everyday operational spending to long-term investments. Accurately tracking and managing these costs is the key to everything from staying profitable to adapting to changes in the market. So let’s dig into how these costs work, how to calculate them and how to reduce costs when you need to.

What business costs do I need to know?

Business costs can be broadly categorised into three types: fixed costs, variable costs, and total costs.

• Fixed Costs are expenses that remain constant regardless of the level of production or sales. Think rent, salaries, and insurance premiums. They provide stability but also require careful management to avoid financial strain when other costs change.
• Variable Costs fluctuate with your level of business activity. These costs include raw materials, utilities, and shipping. Managing variable costs effectively is crucial for maintaining profitability as they can quickly increase with higher production levels. Note: salaries, while they can rise with hiring activity, are generally considered a fixed cost unless applied to labour directly involved in production.
• Total Costs represent the sum of fixed and variable costs, providing a high level view of all your business expenses. Understanding total costs is essential for all your big picture planning – think pricing strategies, budgeting, and financial planning.

The way you manage these costs have a direct impact on your business's bottom line. Here we’ll explore the factors that affect costs in your business and how you can reduce costs to make your money go further.  

Fixed costs: What they are and how they work

Fixed costs are expenses that do not change with the level of production out or sales – staying the same no matter the rest of the activity going on in your business. 

These costs provide financial stability and predictability, since you have to pay them no matter what you’re doing. Making sure you can meet your fixed costs is the basis for basic financial planning and consistent business operations, since they have less flexibility by nature compared to variable costs.

Examples of Fixed Costs

• Rent: Payments for leasing business premises.
• Salaries: Regular employee wages, not including performance-based bonuses.
• Insurance Premiums: Costs for policies such as general liability, property, and health insurance.
• Loan Payments: Scheduled repayments on business loans or mortgages.

How To Calculate Fixed Costs Example

To work out your fixed costs, add up all your recurring monthly or annual expenses that remain unchanged regardless of business activity. 

1. List All Costs

To start, list every monthly expense your company has. Use budgets, receipts, and bank account transactions to get a comprehensive view. For annual expenses, divide by 12 to get the monthly figure. It’s best to list all your expenses on a spreadsheet for clarity.

2. Figure Out Fixed Costs and Keep Variable Costs Apart

Next, divide your list of expenses into fixed and variable costs. Fixed costs are ongoing expenses that do not fluctuate with sales volume, while variable costs change based on sales or production levels.

Example: B. Smith Ltd. separates its expenses into fixed and variable costs. They identify the following as fixed expenses:

• £2,500 for facility rent
• £25,000 for staff salaries
• £1,200 for equipment leases
• £150 for website maintenance
  
  

3. Add Fixed Costs

Add together all the monthly fixed expenses to get your total fixed monthly cost.

Example: To determine its overall fixed costs, B. Smith Ltd. sums all its fixed expenses.

• £2,500 (facility rent) + £25,000 (staff salaries) + £1,200 (equipment leases) + £150 (website maintenance) = £28,850

B. Smith Ltd. now knows that their monthly fixed costs amount to £28,850. To establish the appropriate pricing for their furniture, they must ensure that their prices cover this fixed cost to break even.

Variable Business Costs: Dynamic Expenses 

Variable costs are expenses that vary depending on activity levels or sales volume since they increase as production increases and decrease as production decreases. 

This is why variable costs are so essential for maintaining profitability, as they can significantly impact the cost of goods sold and overall financial returns for your business. 

Examples of Variable Costs:

• Raw Materials: The cost of materials used in production.
• Direct Labour: Wages paid to employees directly involved in manufacturing.
• Shipping Costs: Expenses related to delivering products to customers.
• Sales Commissions: Payments made to sales staff based on the volume of sales.

Example: Calculating Variable Costs

To see why variable costs are so important, consider the example of B. Smith Ltd. again, which makes furniture. To calculate the variable costs for producing 200 units of furniture, we multiply the cost of producing each unit by the total number of units produced.

How Variable Costs Affect Profit

Variable costs have a direct relationship with profit margins. 

• As variable costs increase, the cost of producing each unit of a product also increases, which can reduce profit margins if sales prices are not adjusted accordingly. 
• Conversely, reducing variable costs can enhance profitability by lowering the overall cost of production. Analysing the impact of changing variable costs is essential for making informed pricing and production decisions

For example, if you’re trying to scale production, you may be able to produce more goods and, therefore, more revenue, but if your variable costs are rising as you grow, you’re making less and less profit per product.

Total Costs in Business: The Big Picture

As  the name implies, total costs in business represent the sum of all fixed and variable costs – the figure provides a complete picture of the overall expenses incurred in running a business, helping owners and managers to set appropriate pricing, budget effectively, and plan for growth.

How to Calculate Total Costs

Calculating total costs is a straightforward straightforward formula, building off the cost formulas discussed so far.

Total Costs = Fixed Costs + Variable Costs

This calculation helps businesses to understand their overall financial obligations and to plan accordingly.

Example Calculation: If B. Smith Ltd. has fixed costs of £28,850 and variable costs of £20,000, their total costs would be:

• Total Costs: £28,850 (fixed costs) + £20,000 (variable costs) = £48,850

How To Use Total Costs

Setting Appropriate Pricing to Cover All Expenses

Your total cost is the figure that all revenue needs to make up for. While fixed and variable costs are managed in their own workflows, total cost is the overall target for your pricing and profit scenarios.

Determining Your Break-Even Point

The break-even point is where total revenue equals total costs, resulting in neither profit nor loss. Calculating this point helps businesses understand the minimum sales needed to cover all expenses.

• Break-Even Formula: Break-Even Point (units) = Fixed Costs / (Sales Price per Unit - Variable Cost per Unit)

Example: If B. Smith Ltd. sells their furniture at £300 per unit and the variable cost per unit is £100, their break-even point would be:

• Break-Even Point = £28,850 / (£300 - £100) = 144 units

Forecasting Profit Potential Based on Various Sales Scenarios

By projecting different sales volumes and calculating the associated total costs and revenues, businesses can forecast potential profits and plan for various financial scenarios.

Example: If B. Smith Ltd. forecasts selling 300 units:

• Total Revenue = 300 units x £300 = £90,000
• Total Costs = £28,850 (fixed costs) + (£100 x 300) = £58,850
• Profit Potential: £90,000 (total revenue) - £58,850 (total costs) = £31,150

How to cut costs 

It’s important to remember that reducing costs should not be a goal in itself – reducing your costs too much can lead to tying your hands with not enough resources or flexibility. The goal is to keep costs in line with your pricing and goals to ensure you’re making the most of the resources available.

Reducing Fixed Costs

Fixed costs tend to have a more limited scope for reduction, given that they can be based on long term agreements and fixed scenarios. However, these deals should be reviewed on a regular basis to ensure they’re fit for purpose.

• Renegotiating Contracts and Leases: Regularly review and renegotiate contracts and leases to ensure you are getting the best possible terms. Given the current economic environment, landlords may be more willing to negotiate favourable rental agreements, for example renegotiating your office lease to secure lower rates or more flexible terms if your full time team shrinks due to remote work.
• Optimising Your Office Space and Energy Usage: Evaluate how efficiently your office space is being used and look for ways to reduce energy consumption. Moving to a smaller office, adopting a remote work model, or using co-working spaces can significantly cut costs.
• Identifying Unnecessary Subscriptions and Services: Audit of all your subscriptions and services to identify those that are no longer necessary. 

Lowering Variable Costs

Variable costs are the dynamic levers you can use to manage your profit margins on a per product margin, so require frequent analysis to ensure your projections are on track.

• Regularly Review Alternative Suppliers: Compare prices from different suppliers to ensure you are getting the best deals on raw materials and other variable costs. A broad network of relationships with multiple suppliers can also provide leverage for negotiating better terms.
• Prioritising Expenses Based on Their Impact: Not all expenses are created equal. Identify which costs have the most significant impact on your business operations and prioritise them. Cutting low-impact costs first can help maintain business performance while reducing expenses.
• Regularly Reviewing and Updating Your Budget: Work with your financial partners to create budget processes to review and update costs to reflect current business conditions.

Using Short-Term Finance to Manage Costs 

With market conditions constantly changing, business owners need flexibility to manage costs in real-time. Short-term finance can provide the flexibility needed to address unexpected expenses, seize new opportunities, and smooth out cash flow fluctuations. 

• Bridging Cash Flow Gaps: Many businesses experience seasonal fluctuations in revenue. Short-term finance can help bridge the gap during slower periods, ensuring that you can cover fixed and variable costs without disrupting operations, such as using a short-term loan to stock up on inventory ahead of the busy holiday season and manage expenses during the off-peak months.
• Covering Unexpected Expenses: Unforeseen expenses can arise at any time, whether it’s urgent equipment repairs or a sudden increase in raw material costs. Short-term finance provides the liquidity needed to address these issues promptly, preventing them from escalating.
• Supporting Growth and Expansion: Short-term finance enables businesses to act swiftly, whether it’s launching a new product line, entering a new market, or capitalising on a limited-time offer from a supplier.
• Investing in Marketing and Sales: Growing businesses need to invest in marketing and sales initiatives to keep leads and revenue moving. Short-term finance can fund targeted campaigns and promotional activities that generate immediate returns, such as taking out a short-term loan to run a targeted social media advertising campaign, boosting traffic and sales during a key promotional period.

iwoca for Flexible Short-Term Finance

Iwoca flexible short-term finance solutions are build around the needs of SMEs to help them manage costs and move with the market. Our Flexi-Loan offers quick decisions in as little as 24hrs, with transparent terms and interest rates. 

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