To accurately assess the profitability of a business plan, managers must distinguish between fixed and variable costs. Planners should then further dissect these figures, paying particular attention to what portion of fixed costs can be reduced if needed, versus committed payment obligations. Such a cost analysis will help you select the best course of action.
Fixed vs. Variable Costs
Costs that increase in proportion to the level of output are termed variable costs; expenses that are independent of output levels are referred to as fixed costs. For example, the cost of flour and sugar are variable costs in a bakery. Rent, however, is a fixed cost. Some costs can be difficult to categorize. In our example, the bakery may hire a temporary sales clerk when sales tend to be particularly strong, and the cost of this employee can be classified either as fixed or variable depending on the analyst's perspective.
Committed Fixed Costs
A committed fixed cost cannot be eliminated without incurring either legal penalties or seriously damaging the profitability and long-term viability of a business. Rent is one such cost and must be paid in order to avoid a damaging lawsuit. Similarly, all other contractually obligated costs that do not depend on production levels fall under the same category. A soft drink manufacturer may have committed to paying a TV producer a million dollars per year to sponsor a talk show, for example, making this a committed fixed cost. Similarly, settlements resulting from lawsuits and retiree benefits must be paid to avoid serious repercussions.
Discretionary Fixed Costs
Fixed costs associated with activities that are not legally mandated, but at the sole discretion of management are considered discretionary fixed costs. Advertising, for example, is a fixed cost in that it is independent of how many units you manufacture. Since a business is free to stop advertising at any time, it is a discretionary fixed cost. Other examples include employee training, research and development as well as employee incentives such as gift cards. Severe cuts in most fixed costs, such as advertising or research, may impact the long-term profitability of a business and should be carefully considered.
Whether you are running a small business or a multinational entity, you should have a very clear idea about the level of committed as well as discretionary fixed costs. This will allow you to establish the minimum amount of cash flow you must divert to fixed expenditures to be able to continue running your business. If committed fixed costs for the next year are half a million dollars, this is how much money you must come up with or you risk shutting the doors. This figure determines how much you must manufacture, sell or borrow at the very minimum to stay afloat.