Covering fixed and variable costs

Every business needs to cover its costs to make a profit. Working out your costs accurately is an essential part of pricing.

Your costs can be divided into:

• fixed costs that are always there, regardless of how much or how little you sell, for example rent, salaries and business rates
• variable costs that rise as your sales increase, such as additional raw materials, extra labour and transport

When you set a price, it must be higher than the variable cost of producing your product or service. Each sale will then contribute towards covering your fixed costs - and making profits.

Example of fixed and variable costs

For example, a car dealership has variable costs of £9,000 per car sold and total fixed costs of £200,000 a year that must be covered. If the company sells 80 cars each year, it needs a contribution towards the fixed costs of at least £2,500 per car (£200,000 divided by 80) to avoid making a loss.

Using this structure, you can assess the consequences of setting different price levels:

• if the car dealership sells cars at less than £9,000 (the variable cost per car), it makes a loss on each car it sells and does not cover any of its fixed costs
• selling 80 cars at £9,000 means a loss of £200,000 per year, as none of the fixed costs are covered
• selling cars at £11,500 results in breaking even, assuming the target 80 cars are sold (80 contributions of £2,500 per car = £200,000, ie the fixed costs)
• selling cars at £12,000 results in a profit, assuming 80 cars are sold (80 contributions of £3,000 = £240,000, ie £40,000 over the fixed costs)
• if more or fewer than 80 cars are sold, profits are correspondingly higher or lower