What is a cost analysis?

Fixed and variable costs refer to the categorization of business expenses depending on whether they are affected by changes in product/service quantity sold, or whether they remain constant regardless of quantity sold. Being able to categorize costs appropriately is a critical step for budgeting and in determining a business’s breakeven point (i.e., where revenues exceed costs). 

Why is it important?

Understanding which costs vary with the amount of product/service sold vs. those that don’t is critical in order to:

• Budget appropriately – understanding which costs will be incurred regardless of sales volume
• Benchmark appropriately – understanding common industry benchmarks in order to understand where your ESE’s operations might be out of line
• Make targeted cost reductions – by focusing on the cost buckets that are most significant, and where cost reductions will have the most significant impact on the bottom line
• Determine breakeven levels – understanding how many units the ESE needs to sell or at what average monthly/yearly/etc. sales volume in order to turn a profit 

Best Practices

Distinguishing and categorizing fixed vs. variable costs 

Fixed costs are expense types that do not vary depending on the amount of business transacted (i.e., number of units sold, or amount of service performed). Rain or shine, these are the expenses an ESE will have to cover no matter what. A good example of a fixed cost would be rent. An ESE will pay monthly rent regardless of how the business is performing. 

Variable costs, on the other hand, vary (as the name implies!) with the amount of business transacted. Variable costs increase as sales volume increase, and decrease as sales volume decreases. A simple rule of thumb for whether the cost is variable is to ask: if I were to sell one additional unit (e.g., one additional candle), what changes on my income statement? What additional costs has the ESE incurred? The expense categories where you see change are your variable costs. A good example of a variable cost would be the materials needed in the direct production of a good or service. In the case of an ESE selling candles, these material costs would include things like the wax, the wicks, and the containers. 

Between these more clear cut examples, though, there is a good deal of gray area. Let’s take labor for example. Should wages paid to participant workers be classified as a fixed or variable cost? Consider the rule of thumb posed earlier: will these labor costs increase if we sell one more unit of product/service? If the answer is yes, those labor costs are variable. If the answer is no, they are fixed. Here’s how REDF generally thinks about labor in particular: 

• Wages paid to participants in ESE businesses that are more service (people) based are generally considered variable. E.g., for staffing businesses (where workers are paid an hourly wage per hour staffed) or on crew-based businesses (e.g., a street-cleaning crew that will get paid per hour on the job). 
• For product based businesses (e.g., candle making), it’s a little less straightforward. Wages associated with the direct creation of a product should be considered variable (i.e., the time paid for a worker to fill candles with wax, place the wick, etc.) but oftentimes, workers in these businesses are paid for time off the production line or are guaranteed a certain number of paid hours per week regardless of production. Any predictable wages paid should be classified as fixed. 
• Some ESEs will guarantee a certain number of paid hours per month per employee. If this is known in advance – and will not vary depending on quantity sold, it is a fixed cost. Consider perhaps the weekly payroll for a cafe. The cafe may need 4 workers at 32 hours a piece to run the shop – and this will be the case regardless of how many coffees the cafe sells. Here, classifying the weekly payroll as fixed would make more sense. 
• Professional, salaried staff are generally classified as a fixed cost. E.g., the salary paid to a crew supervisor, the business manager, etc. These salaries are generally paid regardless of the specific production amount. 

Common fixed and variable cost
Common Variable Costs	– Cost of materials needed to produce what you are selling – Labor costs that vary with production / service – Fuel needed for transportation related to delivery of product or service
Common Fixed Costs	– Facility space cost – Equipment cost  – Management overhead cost

Putting into practice your understanding of fixed and variable costs 

There are many ways an ESE can put its knowledge of fixed and variable costs to use. REDF generally suggests ESEs focus on three priority areas: budgeting, cost reduction, and breakeven analysis. 

Budgeting

Creating an annual budget is a core function of any ESE. Within the budget, it’s important to understand which expenses will need to be covered regardless of how the ESE is functioning vs. which will likely vary. If an ESE knows which expenses are fixed and which are variable, it becomes much easier to put together a budget that will have small budget-to-actual variance. 

Relatedly, often ESEs will want to understand how their financial performance or cost structure stacks up against their peers (in the ESE or for-profit world). In many industries, performance benchmarks are often calculated in terms of fixed or variable cost percentages (e.g., in the restaurant industry, <70% variable costs; <20% fixed costs as a percent of revenue). These benchmarks will only make sense if an ESE can translate its own situation into similar categories!

Targeted cost reductions

We know that business profit is the difference between total revenue and total costs (i.e., profit = total revenue – total costs). This means that when an ESE reduces its costs, profit increases! But it’s important to know which costs are worth reducing. Depending on an ESE’s cost structure, it may make sense to target reductions in variable costs (e.g., reducing materials per unit produced). In other instances, the right move might be to target how to reduce fixed costs in the long-run. Let’s consider two ESE examples.

Example 1

In our first example, let’s imagine the cost structure of a small temporary staffing enterprise. Here’s what its cost and billing structure may look like:

Category	Amount (monthly basis)	Cost classification
Hourly billing rate to customers	$30	N/A – not a cost
Hourly wage rate	$22	Variable (wage paid per each staffing hour billed)
Hours billed	800	N/A – associated with the hourly wage rate (and therefore variable), but not technically a cost in and of itself
Professional staff salaries	$6,000	Fixed (paid regardless of how many hours billed for)
Office rent	$3500	Fixed
Utilities	$400	Fixed (not tied to number of hours billed)
Other miscellaneous	$300	Fixed (imagine office supplies and permits and such)

Well, what should the ESE consider if it wants to get out of the red and into the black?

What should it consider? One of the first steps would be to figure out whether it can bill more hours or charge more per hour. We definitely recommend considering this! See our pricing overview for more information here. But what if those levers have already been exhausted? What if we want to target cost reductions instead? 

Here’s where the fixed and variable components come into play. We know that variable costs ($17,600/$24,000 = 73.3%) comprise a larger percentage of the cost structure than fixed costs ($10,200/$24,000 = 42.5%). This means that if the enterprise were able to reduce either variable or fixed costs by 10%, they would see a bigger bump to their bottom line if they were to focus efforts on reducing variable expenses. Variable expenses may also be easier to reduce (e.g., reducing a participant’s pay rate), though could be considered antithetical to the ESE’s overall mission. 

Example 2

Let’s run through an example of a second ESE – in this case a cafe – a bit more quickly:

Category	Amount (monthly basis)	Cost classification
Category	Amount (monthly basis)	Cost classification
Number of unique tickets/transactions	2,500	N/A – not a cost
Average receipt value	$12.50	N/A – not a cost
Food and drink costs	$12,500	Variable – directly associated with items sold
Monthly participant worker payroll	$8,000	Fixed – in this case, the ESE budgets for this level of cafe staff regardless of the number of new tickets
Professional staff salaries	$2,000	Fixed (paid regardless of how many hours billed for)
Building rent	$6,000	Fixed
Utilities	$700	Fixed (not tied to number of hours billed)
Other miscellaneous	$2,000	Fixed (imagine supplies, permits, depreciation and interest)

Target cost reductions using benchmarking data

When thinking of targeted cost reductions, the ESE might consider which bucket of costs is larger – in this case, fixed costs by a decent margin. Does the monthly rent justify the sales volume? If not, should the cafe consider a move in the medium term? 

The data broken out in this way might also be helpful for benchmarking. The restaurant industry has good data on basic benchmarks.The rule of thumb we’ve come across is that food and drink costs should be roughly 30% of sales, labor 25%, operating expenses like utilities and marketing at 15%, and fixed costs such as rent and depreciation at 20%. Comparing this business’s costs with those benchmarks, you’ll note that labor and fixed costs are slightly higher than would be normally desired. 

Connection to breakeven analysis

A breakeven point for a business is the amount of sales (or quantity of units sold) such that total revenue is exactly equal to total expenses. At the breakeven point, profits equal zero! It’s super important for an ESE to have a clear conception of its breakeven point so that it can plan a sales strategy effectively, consider pricing adjustments, or consider targeted cost reductions. 

An ESE cannot calculate its breakeven analysis without a clear understanding of fixed and variable costs!

An ESE can calculate a breakeven point for really whatever metric it is most focused on. Over 90% of the time, though, we see ESEs consider two versions of breakeven: the number of breakeven units (i.e., how much sales volume should they target) or the total sales breakeven point. Here are the calculations for each:

Breakeven units = total fixed costs / (unit price – unit variable costs)

Breakeven sales = total fixed costs / (1-[total variable costs / total sales])

Let’s bring back the two ESE examples from the prior section and understand these breakeven points for both: 

ESE #1: Staffing Agency 

• Total fixed costs = $10,200
• Total variable costs = $17,600
• Unit price = $30
• Unit variable cost = $22

Breakeven units = 10,200 / (30-22) = 1,275 hours billed. 

They are currently billing 800 hours. This means that at current rates, they would need to bill 1,275 – 800 = 475 more hours in order to breakeven 

Breakeven sales = 10,200 / (1-[17,600/24,000]) = 10,200 / (1-.733) = $38,250. 

They are currently doing $24,000 worth of business per month, meaning they’d have to do an additional $14,250 in order to breakeven. Let’s check the math: what is 475 * 30? $14,250. 

ESE #2: Cafe

• Total fixed costs = $18,700
• Total variable costs = $12,500
• Unit price = $12.50
• Unit variable cost = 12,500 / 2,500 = $5

Breakeven units = 18,700 / (12.5 – 5) = 2,493 transactions

They are currently doing 2,500 transactions per month, which is above the breakeven point. They are slightly profitable, so this checks out. 

Breakeven sales = 18,700 / (1-[12,500/31,250]) = 18,700 / (1-.4) = $31,167

They are currently doing $31,250 worth of business per month, meaning they are slightly above the breakeven point. 7 transactions at $12.50 a piece would yield $87.50 in additional sales, which added to $31,167 = ~$31,250 (slightly off due to rounding). 

Implications: 

• This is super important information for the ESEs! For the staffing agency, we can see right away that it may be quite tough to reach a breakeven point through increasing sales volume alone (475 hours more on top of 800 is a big jump). In their case, they might consider pricing adjustments, or looking for ways to reduce different cost buckets. 
• For the cafe enterprise, they’re in a different situation since they’ve already breached the breakeven point. They may be in more of a position to bolster profit cushion by both driving new volume and by looking at ways to reduce costs (particularly some of their fixed costs, which seem out of line with industry benchmarks). 

Concrete ideas on how to reduce costs (some repeated from above)

• Focus on large cost categories first
  • Using the cost data contained within the accounting system, determine the categories responsible for the bulk of the business’s expenses 
  • Prioritize these areas for cost reduction, since even incremental changes can have a significant impact on total costs 
• Make incremental changes
  • Consolidate activities to save on costs 
  • Reduce material wastage (e.g., instead of utilizing new materials for brand new trainees, use leftovers for practice)
  • Reduce FTE overhead by allowing proficient workers to operate semi-autonomously after the successful conclusion of the training period 
  • Attempt to re-negotiate rates with suppliers where possible, such as for bulk purchases 
• Redesign, reorganize, and eliminate 
  • Review business processes to identify the most time-consuming, labor-intensive processes and brainstorm ways to streamline them (see process overview document for more information on streamlining processes)
    • Consider conducting a bottleneck analysis
  • Identify where materials are often wasted as a result of inefficient processes and implement preventive measures 
  • Determine which long-time standing processes add value, versus which can be eliminated  
  • Consider closing down product or service lines that generate an outsized proportion of costs and that don’t contribute substantial revenue
• Solicit suggestions from staff members
  • Often, front-line workers have the best vantage point from which to diagnose organizational inefficiencies
  • Conduct regular check-ins with managers and participants to surface novel cost-reduction ideas 

Additional Resources

Introduction to social costs: Learn more about social costs – costs you incur above and beyond ordinary business costs due to your social mission – and understand how you can identify and quantify them. Distinguishing social costs from ordinary business costs enables you to make more informed decisions on managing your budget and making targeted cost reductions.

Double Bottom Line (DBL) Starter Kit: Use this template to create and analyze your own DBL income statement.

Break even analysis template: Use this template to conduct a breakeven analysis and determine the sales volume required to reach the breakeven point for your business