Your Gross Profit either covers your Fixed Costs or it doesn’t. You are 100% guaranteed a loss whenever it doesn’t unless you have enough Other Income to cover the shortfall or can talk those you pay money to not charge you for their products and services.
You protect yourself from losing money by maximizing your Gross Profit while keeping your Fixed Costs within an acceptable range of what your business can afford. Business Owners who allow their Fixed Costs to increase unchecked are the same people who wonder why they never have any money in the bank.
Overview
To make a profit, you must cover both your direct (variable, COGS) and indirect (fixed, SG&A, overhead) costs in the prices you set for your goods and services. Overhead absorption is the indirect costs not directly traceable to an activity or product you must cover in your Gross Profit Margin. Any fixed costs that are considered a cost of doing business must be paid through any sales dollars you collect or eliminate the cost.
Any money spent that isn’t covered through your product and service pricing models is an immediate loss to your business. An Overhead Absorption Rate is calculated, most simply, by dividing variable costs by total fixed costs. This is the overhead rate that should be added to all direct costs and considered when calculating the price you will charge for your products and services. Failure to include this figure in your pricing decisions robs you of profits.
The formula for calculating your Overhead Absorption Rate
Total Fixed Costs / Total Variable Costs
If your average fixed cost per day is $1,200 and you take in $3,000, then you have $1,800 to cover your direct costs at a profit. If you reduce your fixed costs by $200 and still take in $3K, you now have $2,000 to cover your direct costs at a profit. Do this through 220 workdays, and you will earn an additional $44K because you spent less on overhead.
Lower Creates Opportunity: the less fixed costs you have to pay, the less stress you carry each time these expenses come due.
Higher Creates Challenges: the higher your fixed cost base, the higher your risk of not charging enough to cover your inefficiency and waste.