Sufficiently cover fixed expenses for your firm’s survival and growth

When establishing a business, it is right to start on the right footing and knowledge of potential sales volume is key. PHOTO | FILE 

By ODINDI WERE

The two main objectives of a business person is first and foremost making money (known as profit) and then ultimately wealth maximization. It is important to start on the right footing and knowledge of potential sales volume is key
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When accurate sales forecast are unavailable, an educated approximation on the potential demand will be key. Demand forecast is a determinant of the expense structure of a business. Otherwise the business may live beyond its means (just like individuals sometimes do).

There are typically two types of expenses, namely variable and fixed with a third one, though not prominent, know as mixed (a blend of variable and fixed).

Variable expenses as the name suggests move up or down with the movement in sales volume.

For example, total raw materials expenditure is guided by forecasted or demand-driven product units.

Our assumption in this discussion is that the average variable prices remain constant over a reasonable period of time, otherwise sales price will have to be adjusted upwards to cover for increase in unit variable price.

If not a single unit of a product is produced, the total variable expenses will be nil. Variable expenses are therefore easier to control over a reasonable period of time.

There are however expenses that appear variable in nature but have a fixed component. Electricity consumption is one of them.

If you scrutinise your electricity bill, you discover that there are charges which are constant and they do not vary with how much power you have consumed.

Your focus should be managing the variable elements by for example, eliminating waste or producing more units per period of time hence reducing the overall variable expenses (being more efficient).

Fixed expenses are a stubborn lot and can deny a business breath. It is crucial and imperative to cover fixed expenses for the business to survive.

At the level where neither profit nor loss is made, the product or the company as a whole is said to be breaking even and the unit of sales or revenue at this point is known as the break-even point.

At break-even point, the sales revenue generated is merely covering fixed costs. Operating below break-even point is not sustainable because fixed expenses are not being covered.

It should be noted that fixed expenses cannot be avoided because the cash outflow related to them are contractually agreed or committed like rent, bank interest on long term loans, salaries of permanent employees whose engagement with the company is not dependent on sales volumes, unless the company shuts a division, discontinues a division or product line, or ceases to exist altogether.

Operating below break-even for a long period of time with no turn-around in sight is a bad business decision. More so because the company will be forced to borrow to finance operations.