Managing Small Business Cost Structure

Managing Small Business Cost Structure

Business owners have to wear several hats, and all are important to running a successful enterprise. The Finance hat should be given a considerable amount of time, considering that cash flow kills businesses more than any other reason. For many small business owners, managing costs is arguably at the very top of the priority list. There are two types of costs to consider and we discuss them in this article.

When considering managing costs, there are two primary types of costs that should be given attention: Fixed costs and variable costs.

Variable Costs
Variable costs are the expenses that go into making a product or providing services. For example, variable costs for a restaurant are food items purchased for resell. Variable costs include inventory items, hourly direct labor, shipping expenses and others. These costs will go up when sales are high and down when sales are low. Business owners should take a lot of care in managing variable costs, because they directly impact the quality of your product or service. Simply finding the lowest cost may not be the best strategy though. For example, a high-end retailer like Saks Fifth Avenue can’t sell low quality items and expect to stay in business. The items cost less, but will have an inferior quality. Therefore, a higher cost can be justified. Wal-Mart can sell low cost items, because its business strategy is to offer low priced items. We don’t go to Wal-Mart to purchase an Armani shirt. Companies spend a great effort managing their supply chains to balance cost with quality.

Fixed Costs
Fixed costs are expenses that are stable over time. These are costs that are generally the same or similar every month. Examples include rent, lease, interest, certain utilities, internet, etc. Business owners should keep these expenses as low as possible. High fixed costs can destroy a business quickly. These costs do not fluctuate with your level of sales, so they are there whether you have banner year or a horrible year. Your business has to cover these costs regardless of how well business is going. Keeping these costs at the lowest possible level will allow you to weather a storm such as the current slow economy. Many companies with high fixed costs are really struggling right now, as they have really high expenses and few sales. Some businesses have high fixed costs, as this is the nature of the business. Businesses that require large and expensive equipment to make a product would be an example. Businesses in this category should still attempt to keep fixed costs as low as possible, though they may be higher than many other businesses

Gross Margin
Of course, sales pay for expenses. As long as variable costs are lower than the sales price of items, a business has cash left over to pay for fixed costs. Will a business have enough though? This is why getting fixed costs to an optimal level is extremely important. Many companies have cost variabilization strategies for their cost structure. In essence, the idea is to increase the percentage of costs that are variable versus fixed. This allows them to weather a long period of low sales. It also may be the best strategy to compete in their market.

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