Understanding Fixed and Variable Costs and Burn Rate

Costs are among the financial and accounting terms that have specific meanings. You can’t just decide to think of them as what makes sense to you, because the accountants and analysts won’t understand you. They’ll say you are wrong. Ouch. Not pleasant.

So, here are some definitions.

Cost of Sales

The cost of sales is not the expenses related to making a sale. It isn’t that lunch with the customer or the trip to go visit the customer and make a pitch. Costs of sales means what it costs you to make or deliver whatever it is you sell. If you don’t sell, you don’t have any costs. The costs are variable by definition.

• Costs are supposed to be directly related to sales. They are about what it costs you to have or build or deliver what you’re selling.
  • Costs of a manufactured product include materials and labor. So, for example, the computer costs $200 to build, including $150 in parts and $50 in labor.
  • If you just buy an already-built computer and then sell it, the cost is what you paid to buy it.
  • If you deliver a service, you still have costs. The taxi or airline has fuel, maintenance, and personnel costs. The law firm has what it pays the lawyers, plus legal assistants, and photocopying and research.
• Costs depend on who and when. For example.
  • When you buy a book for $19.95 at the local bookstore, the store’s cost of goods sold are whatever it paid to buy that book from the distributor. Let’s say it paid $10.50 plus shipping. The store’s sales are $19.95 and it’s cost of goods sold is $10.50 plus shipping.
  • If the distributor bought the book from the publisher for $6.25, then it’s sales for the book is $10.50, and its cost of goods sold is $6.25.
  • Let’s say the publisher had the book printed for $2.00 per copy and it pays the author a royalty of 10%. It’s sales for the book is $6.25 and its cost of goods sold is the $2.00 plus $0.652 for royalty. And the publisher probably paid to ship the book to the distributor, which would add another small amount, maybe $0.25 to the cost of goods sold.
• Understand inventory. This comes up again as a cash-flow trap.
  • Stuff that’s going to become cost of goods sold when it sells starts out as inventory, which is an asset. It sits there in inventory until it sells.
  • Think about this in terms of timing and cash flow. The publisher buys the books from the printer and pays for them, which makes them inventory. They sit there for months until the distributor buys them, at which point they become cost of sales. The distributor has them as inventory until it sells them to the store. Then they become cost of sales. The store has the book for as long as it takes, from when it receives it and puts it on the shelf until you buy it.
  • The cash-flow trap is that the whole inventory asset doesn’t show up on your income statement until you sell the stuff. In the meantime, whether you’ve paid for it or not, the income statement doesn’t care. The money is gone, but the sale hasn’t been made. This is a classic cash-flow trap. You won’t see it on the income statements. It is completely outside of the realm of profit and loss. But you have spent the money.

Here’s where you rate yourself. If these ideas are obvious, then skip this next part; don’t worry about it. If you’re uncomfortable with these terms, vaguely worried you don’t know what they mean, then read on, and in about five minutes, you will.

Fixed vs. Variable Costs

Part One: The Real Case — Manufacturing Costs

Sometimes this matters, many times it doesn’t. Technically, fixed costs are costs that you pay regardless of whether or not you sell anything, or how much you sell. For example, the monthly rental of an installation used exclusively to build stuff would be a fixed cost. It gets technical and surprisingly creative as cost accountants figure out how to allocate fixed costs to the related sales. That was a special course in business school. I found it fascinating, but for business planning purposes, let it go.

We’re doing planning, not accounting. Remember?

Part Two Fixed vs. Variable and Risk

Don’t worry too much about financial definitions, because in this case at least, they are inherently confusing. Analyists tend to talk about fixed vs. variable costs, but most of the time they are talking about variable costs (as in cost of sales, direct cost of goods, costs of goods sold) vs. fixed expenses (such as payroll and rent). This is not a useful context for distinguishing between costs and expenses. Basically what this is about is trying to figure out how much risk you have in the business.

The big picture is relatively straightforward. The underlying assumption is that your spending has two parts: the fixed part, that you spend no matter what, and the variable part, that you spend only if you make the sale, and for which the level of spending depends (hence the term variable) entirely on the level of sales.

For an example of that, here’s a true story. Back in the formative years of Palo Alto Software we chose to pay an outside sales representation company 6 percent of our retail sales, after the fact, rather than hire somebody as an employee to manage retail sales.

The trade-off should be obvious. There’s a lot less risk with the variable cost. If we don’t get the sale, we paid nothing. If we did get the sale, then we had money from the sale that we could use to pay the variable cost.

Some of your spending is almost always fixed: rent, insurance, payroll, for example. Some of your spending is almost always variable: direct cost of sales, for example.

And some of your spending is hard to classify. The plumber pays the Yellow Page advertisement in the telephone book once a year, regardless of sales levels; but if sales go up because of the ad, she might be tempted to increase the ad size next year. Your website seems like a fixed cost, but many of us in the Web business pay commissions to affiliated sites that help us make the sale.

It’s fine-tuning like this that has given us the term “burn rate.” That term became particularly popular during the first dotcom boom in the late 1990s. Some Internet companies that had no sales or revenue had lots of money from investors. So they would divide the money they had in the bank by their monthly burn rate (how much money they were spending every month) to calculate how many months of life they had. Without sales or revenue, burn rate became very important. They’d use it to know when to look for more investment, or, in some cases, when to look for a new job. Burn Rate, by Michael Wolff, is a very entertaining book about it. You counted your future as how many months’ worth of burn rate you had in the bank, from the investors.

I like using the term burn rate instead of fixed costs. Technically, fixed costs are costs that would stop if you didn’t sell. But the burn rate, on the other hand, is how much money you spend every month, without quibbling over whether it’s technically fixed costs or not. They are closely related.

All of this becomes more than just idle debate and definitions if you try to do a break-even analysis. I think of break-even as mostly optional, but it’s still a good illustration of your basic financial picture. So you might find it worth the effort for a break-even analysis tool. Look in the business calculators of bplans.com. There’s also a detailed break-even explanation at hurdlebook.com.

Your Burn Rate

Your burn rate is how much you have to spend on an average month to keep your company up and running. That normally includes rent, payroll, and — unlike the concepts of fixed vs. variable costs — whatever else you spend in a normal month that isn’t directly tied to your sales, which means it isn’t automatically paid for by sales, whether it’s fixed or variable. So it includes your standard marketing expenses, which would technically be called variable expenses.

I think you should always know your burn rate. I hope you have sales and revenue as well. If your plan calls for burning more money than you’re bringing in, then you know you need to be borrowing or finding investment capital.

I also like the burn rate instead of fixed costs as a good number to use in a break-even analysis. In classic financial projections, the kind they still teach in financial analysis courses in business school, you’d use your fixed costs to calculate your break-even point. Burn rate is a newer and better idea.

Tim Berry

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Tim Berry is the founder and chairman of Palo Alto Software and Bplans.com. Follow him on Twitter @Timberry.