Profitability is a topic we address with our clients all the time. That’s just one area of our business advisory services, but it’s going to be a particularly important one this year.
Most companies look at cutting costs to maintain or improve their profitability. That’s a good strategy, but there are two types of costs in business, and most business owners look at only one of the two categories. They don’t think they can control costs in the other.
Fixed versus Variable Costs
Before we get into cost cutting methods, I thought it would be helpful to define Fixed versus Variable Costs. We routinely see confusion around this topic, so setting a baseline of understanding is probably a good idea here.
Fixed Costs are not related to sales, production, or inventory. They include such costs as insurance, rent, advertising, salaries, and utilities. While fixed costs can vary from time to time, they do not vary as a result of business activity (i.e., sales and production). This is the category on which we find most business owners focus their efforts in cost reduction. That may be because they are easier to evaluate and manage.
Variable Costs are directly related to business activity. These include such items as raw materials and inventory. The reason we call them variable costs is that they fluctuate with your business and sales activity. For example, when you sell more products, you will need to increase your inventory. If you’re a manufacturer, the more goods you produce the more raw materials you will need. Both increase your variable costs.
It may be tempting to look for cost savings by changing your phone or data services provider or reduce other fixed costs. While this is not a bad idea, it’s not a complete solution. In fact, managing variable costs may have a bigger impact, depending on your business model. It may be more difficult to manage variable costs, you need to manage these if you want to maximize your profitability.
Here are a few recommendations for cutting variable costs:
Make Variable Costs an Intentional Target of Your Cost-Cutting Activity
Cutting fixed costs can be more disruptive to operations than cutting variable costs. Take salaries, for example. Cutting salaries means reducing your employee headcount. Need I say more about the pain involved with fixed cost reductions?
Always Monitor Your Variable Costs
Keep track of your finances on a regular basis. Don’t just look at the expenses when you need to improve faltering cash flow or business profitability. Regularly scrutinizing variable costs will create a stronger business overall.
Review every aspect of your business.
Look at every expense, and consider see how each one adds to the value of your business. Does it make any difference to the bottom line? Are there any better, faster, or cheaper options? Growing a more profitable business requires a change in mindset.
Was this blog helpful to you? If so, we’d love to hear from you. If not, please reach out for a complimentary conversation about improving your business profitability. You can schedule that here.