Covering fixed and variable costs
Advice on how to set prices that cover fixed and variable costs including an example of how to calculate this.
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 拢9,000 per car sold and total fixed costs of 拢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 拢2,500 per car (拢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 拢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 拢9,000 means a loss of 拢200,000 per year as none of the fixed costs are covered
- selling cars at 拢11,500 results in breaking even, assuming the target 80 cars are sold (80 contributions of 拢2,500 per car = 拢200,000, ie the fixed costs)
- selling cars at 拢12,000 results in a profit, assuming 80 cars are sold (80 contributions of 拢3,000 = 拢240,000, ie 拢40,000 over the fixed costs)
- if more or fewer than 80 cars are sold, profits are correspondingly higher or lower