A couple months ago, I wrote about the due diligence process that a company should go through in deciding its prospective business relationships. In that column, I made a suggestion in the cost economics section that it is a good idea to look at your costs and determine if you want some of your costs to be fixed and some of them to be variable. But I did not explain what that means or why it is a good idea. So I thought it would be a good idea to discuss that this month: what's the difference between fixed and variable costs, and why would you want some costs to be one or the other?

The distinction between variable costs and fixed costs is necessary to address basic questions, such as how much would the cost-of-goods-sold change if the output level increases by five percent? A variable cost changes in total in proportion to changes in the related level of total activity or volume. A fixed cost remains unchanged in total for a given time period, despite wide changes in the related level of total activity or volume.

Why are some costs variable and other costs fixed? Consider total material costs in your business. Total material costs are variable costs because material is purchased only when it is needed. More material is needed when more orders are being placed and more sales are being produced; as more houses are being built, proportionately more material is acquired and proportionately more costs are incurred.

Contrast the description of variable costs with the fixed costs incurred by your company to lease and maintain your office/warehouse space for a year. Your rent, utilities, and other such overhead costs will be at a fixed rate regardless of how much your production increases (or decreases) throughout the year. Unlike variable costs, fixed costs pay for resources that cannot be quickly and easily changed to match the resources needed or used. This really becomes an issue if production decreases to a level where you notice that your overhead is paying for unused production capacity. If such fixed costs become a burden, there are actions that you can take, like leasing only part of the warehouse space, or subleasing part of the warehouse to other companies.

Do not assume that individual costs items are inherently variable or fixed. Consider labor costs. Labor costs can be purely variable with respect to production when workers are paid on a piece-rate basis. This means that workers are paid on a per-job basis, rather purely by the hour or by salary. The variable method of paying for work on a piece-rate basis is in stark contrast to the fixed method of paying for work when a labor union agreement or an implicit contract with employees has set annual salaries and conditions, contains a no-layoff clause, and severely restricts a company's flexibility to assign workers to any other location that has demand for labor. Japanese companies, for example, for a long time have had a policy of lifetime employment for their workers. Although such a policy entails higher labor costs, particularly in economic downturns, the benefits are increased loyalty and dedication to the company and sometimes higher productivity.

A particular cost item could be a variable cost with respect to one level of activity and fixed with respect to another. Consider annual registration and insurance costs for a fleet of trucks owned by a construction company. Those costs would be variable with respect to the number of trucks owned. But registration and insurance costs for a particular truck are fixed with respect to the miles driven by that truck throughout the year.

Most of the time, when referring to fixed costs or variable costs, the reference point is sales. If the cost fluctuates with sales, then it is variable. If it stays flat while sales fluctuate, then it is fixed. Generally, it is a good idea to make most of your costs variable, in reference to sales, because that would mean that those costs would only increase as sales and production increase. Consider the labor cost for a sales force. Most salespeople are paid on a commission basis, meaning that they only get paid a portion of what they produce. If they don't produce any sales, they don't get paid. This has a two-fold benefit: the company does not have to pay the labor cost if sales are not being made, and commission is a good incentive for a salesperson to try and make as many sales as possible.

How about a case where a variable cost should be converted into a fixed cost? Consider computer maintenance. You may have several instances throughout the year when you experience a computer "disaster," like a hard drive going out, or a severe computer virus infection or internet worm. Losing or corrupting the data in your computer can be devastating, but fixing these isolated incidences can be very expensive, and can be detrimental to your monthly cash-flow. In this case, these costs are variable with respect to computer use. These costs can become fixed by setting up a maintenance contract with a computer servicing company; by paying a fixed amount each month, your cash-flow is maintained each month and these computer issues are still handled effectively.

Look at your various cost items and analyze their behavior. You will notice right away which ones fluctuate and which ones stay flat. Try to understand why each cost item behaves the way that it does over time, and if it is a troubling spot (like material, labor, or insurance can be), see if there are ways to change that behavior.

Some of the examples I used above should be familiar, so start there and look at each item and do this analysis. You'll be surprised at what you might learn about some of your costs and how easy some of them are to manage effectively when just determining whether they should be fixed or variable.

"This article was originally posted on ww.reevesjournal.com."