The Cost of Doing Business

The Cost of Doing Business
OBJECTIVES
⦁ Define and provide examples of fixed expenses
⦁ Explain how variable expenses are calculated
⦁ Define economies of scale
Fixed Expenses
A business tries to earn a profit by selling products or providing
services. Every sale has related expenses, so a business can only
make a profit if the selling price for its product or service is greater
than all of the expenses associated with that product or service.
For example, if you owned a business called Matt’s Hats and
you paid a wholesaler $6 for every hat you sold, you would have
to charge more than $6 for a hat to make a profit. Besides paying
for the hats, you would have other expenses—rent, utilities, and
the other expenses of operating your business. In this chapter, you
will examine how an entrepreneur can determine the actual cost
of each product sold.
What Are Fixed Expenses?

After you start your business, you will have to pay certain expenses
regularly. Monthly expenses typically include rent, Internet access,
salaries, and utilities (gas and electricity). An expense of this type
is called a fixed expense—an expense that isn’t affected by the
number of items a business produces. The business will incur fixed
expenses no matter how many products it sells. For example, if the
rent for your space at Matt’s Hats is $500 per month, it will remain
$500 even if in September your business makes and sells twice as many
items as it produced and sold in August.
Another way of looking at fixed expenses is that they are ongoing
expenses a business must pay to be able to operate. The important thing
to remember is that fixed expenses don’t include expenses directly related
to the products the business sells.
An easy way to remember eight of the most common fixed expenses

is to remember the phrase:
I SAID U R + “Other FXs”

Depreciation
Depreciation is an accounting method of spreading the total cost of
the equipment a business buys over the number of years it will be used.
There are several depreciation methods a company can use. One of the
most common ways of determining depreciation is the straight-line
method of depreciation. The entrepreneur estimates how long the
equipment will last and then figures what it could be sold for at the end
of its business life (this is often referred to as the equipment’s disposal
value or salvage value). Next, to find the total depreciation, the entrepreneur subtracts the disposal
value of the equipment from its actual
cost. Then he or she divides that number by the estimated number of
years during which the equipment will be used. The amount calculated
per year is the depreciation expense.
For example, suppose a manufacturer buys a $25,000 machine. The
manufacturer estimates that the business will use the machine for five
years and then will sell it for an estimated $4,000 (this would be the
disposal value). The total depreciation is $21,000 (the cost of the machine
minus the disposal value). Using the straight-line method of depreciation, you would divide the total
depreciation by the number of years
the machine was used
Fixed Expenses Can Change

The word “fixed” doesn’t mean the expense will never change. It
means only that an expense doesn’t change in response to sales.
For example, if Matt’s Hats needs air conditioning, its electric bills
will likely be higher in the summer than they are in the winter.
The electric bills will fluctuate based on the season. However, they
will not change according to sales. The business might even have
more sales in the winter, when the electric bills are lower.
Here’s another example. Suppose you are an automobile dealer. If
you pay your sales manager $5,000 per month in salary, you will have
to pay that same amount whether the business sells one automobile or a
thousand. This is a fixed expense. Now let’s say that you decide to give the
manager a raise to $6,000. Your business’s fixed expenses will increase by
$1,000 per month, but this figure has no direct bearing on the number
of automobiles your business will sell.
Variable Expenses
As you now know, fixed expenses don’t vary with the amount of product sold. Most businesses have
another type of expense, referred to as a
variable expense. This is an expense that changes based on the amount
of product or service a business sells.
For example, if Matt’s Hats pays its hat supplier $6 per hat, the $6
is a variable expense. If Matt’s Hats sells 500 hats in November, the
total variable expense is $3,000 (500 × $6). If, in December, it sells 600
hats, the total variable expense will be $3,600 (600 × $6). Although the
variable expense per hat remained at $6, the total of the variable expense
changed due to the difference in the number of sales..
The two types of variable expenses are:
⦁ Cost of Goods Sold (COGS). For manufacturing and merchandising (retailing and wholesaling)
businesses, the variable expense that is associated with each unit of sale is called the cost of goods
sold. This includes the cost of materials and labor used to make the product or provide the service.
 Other Variable Expenses. These can include such expenses as commissions for salespeople,
shipping and handling charges, or packaging.
Returning to the example of Matt’s Hats: Suppose you have purchased

hats from a wholesaler for $6 per hat. Because you are buying a finished
product (the hats), no labor or other materials are involved. Your cost
of goods sold per unit is $6.
Let’s say Matt’s Hats prints interesting designs on hats you buy from
a wholesaler. You would still have a variable expense for each hat of $6,
but you also have printing expenses—labor and materials (ink). The cost
of labor and materials is other variable expenses added to your cost of
goods sold. In this case they add another $2.50 per hat. You also have
to pay shipping ($1) and handling ($0.25)
Knowing the variable expenses, you can calculate how much profit
your business makes on each unit sold. Your goal would be to sell
enough units each month to pay your variable and fixed expenses and
have profit left over.
Economies of Scale
Check the prices of paper towels at your local supermarket. The price
of three single rolls will be greater than the price of a three-pack of the
same brand. The supermarket is offering you a lower price if you purchase a larger quantity of
product. Typically in business the price per
unit declines as you buy larger amounts.
Similarly, as a business grows, it may be able to negotiate better prices
from suppliers because it is purchasing larger quantities of goods. The
cost reduction made possible by spreading costs over a larger volume is
called an economy of scale. Two of the most common ways to gain an
economy of scale are:
 Spreading fixed expenses over as much output as possible.

If you have a monthly rent of $500 and you have $10,000 in
monthly sales, 5% of your sales is being used for rent ($500 ÷
$10,000). If you can increase sales to $20,000, you will be paying only 2.5% of your monthly sales in
rent ($500 ÷ $20,000).
Typically, as your fixed expenses per unit decrease, your profit
increases.
⦁ Getting better deals from suppliers. You can get discounts

from suppliers if you buy in quantity. (A discount for buying
greater quantities is called a volume discount.) Typically, as
your cost of goods sold per unit decreases, your profit increases.
For example, normally Matt’s Hats purchases 100 hats at a time
at a price of $6.00 per hat. If Matt’s Hats purchased 200 hats at
a time, the price per hat would be reduced to $5.75 because of
the volume discount.

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The Cost of Doing Business

What Are Fixed Expenses?

An easy way to remember eight of the most common fixed expenses

I SAID U R + “Other FXs”

Fixed Expenses Can Change

Returning to the example of Matt’s Hats: Suppose you have purchased

 Spreading fixed expenses over as much output as possible.

⦁ Getting better deals from suppliers. You can get discounts

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