7 Business Costs Your Business Needs To Be Aware Of

An accurate costing system can improve your business by identifying your most profitable products and services.

By determining which revenue streams may be costing you more than the revenue generated, you can then use this costing analysis to accurately decide which products or services to promote and which to drop or reorganise.

To obtain an accurate costing for any product or service, you basically need to identify your direct costs, such as material and labour and your overheads, such as rent, and add to them any indirect costs, such as administration, which may apply to that particular product or service.

Defining Your Costs

Direct costs are relatively simple to determine. They are directly connected with a business’ goods and/or services, such as wages and materials. Therefore, you can ‘trace’ direct goods to particular goods sold or services provided.

Indirect costs are harder to allocate, since they are associated more with the administration and general running of the business (eg. reconciling bank statements). They are often significant and should be calculated and allocated as appropriate.

Direct labour and material costs are often collectively referred to as production costs. These, together with selling, distribution and administrative overheads, are the business’ operating costs, to which financing costs are added to arrive at total costs for a period.

Costs can also be categorised into:

1. Fixed costs which don’t vary in proportion to the level of the business activity. They are incurred regardless of the level of activity in the business (eg. insurance and asset holding costs).
2. Variable costs which are directly related to business activity. For example, if your sales increase by 10 percent, so too will the variable costs associated with the sale. Examples include telephone, casual wages, delivery.
3. Mixed costs which increase with turnover, but not proportionally. This may include advertising, travel etc.

The way in which costs are measured depends on how the information is gathered and the type of cost you are trying to measure.

Which Costs Vary And Which Remain Fixed?

Every business has some costs which occur no matter what is the level of production and sales. Rent, insurance premiums, equipment lease payments, etc., must be met, regardless of whether you are open for business or not. These are your fixed costs.

Once fixed costs have been incurred they don’t increase with rising sales levels, as long as the size of your business stays the same.

Other costs, like raw materials, are directly related to the level of business activity. If output doubles, these costs usually double. If there is no output, no direct costs are incurred. The distinction between business costs that don’t change with volume (fixed costs) and those that do (variable costs) is crucial for budgeting purposes.

While fixed costs may change as a result of management decisions, inflation, poor cost control, and so on, this doesn’t make them variable. Costs are only variable if they change with changes in production and sales volume.

Here are some examples of both types of costs to give you an idea about what each means.

Fixed Costs:

• Depreciation
• Rent of building
• Leasing
• Rates and utilities (heating, lighting)
• Managerial salaries
• Office Expenses
• Insurance on vehicles or fire insurance
• Loan repayments

Variable Costs:

• Stock purchases
• Sales Commissions
• Freight Costs
• Packaging Costs
• Power consumption
• Incentive payments

Direct vs. Indirect Costs

Fixed and variable costs should not be confused with direct costs and overheads. Direct labour can be variable or fixed depending on the circumstances. For example, administrative labour is fixed while time spent making or repairing items is variable.

Overheads can also vary with volume even though they can’t be directly traced to specific products, for example, sales commissions, warehousing and freight costs.

The relationship between the two ways of classifying costs is shown in the table below:

Mixed and Lumpy Fixed Costs

Several costs are considered mixed costs and have both fixed and variable elements. These costs vary with sales volume, but not in direct proportion. An example of this type of cost is the rental of delivery trucks. Often there is a required monthly fee (fixed cost) with an additional cost dependent upon usage (variable cost).

Time should be taken to properly identify these mixed costs and separate the variable and fixed components.

The easiest way to define these costs is to examine them item by item and classify each cost using your knowledge of what determines how much you spend on it. For example, fixed costs are often time-based, whereas variable costs are normally related to usage.

Not Forgetting The “Lumpy” Fixed Costs

Fixed costs will not be constant for the entire range of possible sales levels; they are only really fixed within a certain range of output (sales). Most fixed costs are “lumpy” or tiered. For example, you can have one delivery truck or two, but not normally one and a half trucks. Hence, when you go from one to two trucks, the fixed cost jumps to the next level, like a step.

Fixed costs will, in most cases, remain constant, as long as your business is operating within a specified range. If sales increase above your existing maximum capacity, however, you may need larger premises, more staff and more equipment, therefore your “fixed” costs will increase.

Once the fixed costs have increased to this new level, they will remain constant, all other things being equal.

In practice, it may not be easy to differentiate costs into fixed and variable categories. This is made difficult because of many mixed costs. The classification is nonetheless worthwhile because it is valuable information when you are budgeting and making strategic decisions.

Hence, it is very important to maintain an efficient and well-designed accounting system that can accurately record all costs incurred. Your accounting system should be complemented by good costing systems to capture the information.