Meridian’s long-time readers already realize the value of analyzing sales, cost of goods sold and expenses in both wholesale and retail operations from prior MFA articles or Meridian seminars. With enormous fluctuations in fuel prices lately, cents-per-gallon data is critical management information. (New readers — cents-per-gallon data is one of the most valuable management tools you can utilize. Percent of sales data can’t work when fuel prices fluctuate.)
While we’ve noticed many long-time readers getting adept at identifying and correcting escalating operational and overhead costs, very few have taken the next critical step — segregating fixed and variable costs on their financial statements. Without this segregation, it’s likely you will fool yourself when it comes to analyzing trends in profitability.
For those non-accountant types who may be unfamiliar with the term, fixed costs are used to describe costs like home office rent, property taxes, headquarters utilities, etc. where no matter what a company’s volume, the dollar amount of those expenses is constant.
Variable costs, on the other hand, vary directly with volume. When volume goes up, these costs go up. A clear example of a variable cost is sales commissions.
So why is it important to segregate fixed and variable costs? Because when volume increases, fixed expenses should decrease on a cents volume basis.
Segregating fixed and variable costs on your monthly profit and loss statements allows you to immediately pinpoint cost escalations, and know the cost savings you should be achieving from growth. Ideally, having subtotals for each category of cost will give you that “at-a-glance,” “easy-to-tell-how-we-are-doing-on-cost-control” look at your business.
There is another big side benefit to segregating fixed and variable costs. That segregation is a valuable first step towards benchmarking controllable costs for pay-for-performance bonus programs. Owners who segregate fixed and variable costs usually find that variable costs are employee generated and controlled costs. Since most good profit-indexed pay-for-performance programs have cost control as one of the key critical numbers, by segregating costs now, you’ll have a head start on any performance pay program. Your employees will be able to view and analyze the specific portion of the profit and loss statement they directly control, and you can link their pay and/or bonuses to how effectively they control those costs. In essence, you will get a double punch from taking the time and necessary effort to segregate fixed from variable costs – management control and employee cost reduction.
If you are now convinced that this is a project you must tackle, start by placing a call to your GL vendor. Most accounting software programs already have the ability to segregate these costs, even though most companies aren’t using that portion of the program. If your vendor does not have a pre-programmed way to segregate these expenses, you can still get it done by renumbering your accounts. This may sound onerous at first, but if implemented on the very first day of a new fiscal year, will be less of a chore than you think. Like anything else, do a cost-benefit analysis. There is tremendous benefit to isolating fixed costs for tighter control of variable costs.
