Behaviours of Costs Explained

How to easily unravel the large variety of cost types & behaviours!

(This is kind of like using Myers Briggs to help understand people’s behaviours)
Because costs are half your profit equation, and as the more profit you have means the richer you are, I’m sure you can now see why understanding all about your costs suddenly becomes pretty important.
Definition of a Cost: An amount that has to be paid or given up in order to get something. In business this relates to production and delivery of a goods or services.
In Part 1 we covered off various types of costs, and found costs types belong to either:

* Direct: costs related directly to manufacturing and stocking goods/services for sale or
or
* Indirect: costs of operating the business as a whole

It is also important to understand how the costs behave, because understanding these two aspects together, cost type and cost behaviour, enables you to know what your costs will look like in the future; will this cost stay the same next month or will it increase as sales increase? And that helps you plan, in a profitable way.

[box type=”info” style=”rounded” border=”full” icon=”empty”] One small thing before getting started:
I am talking about improving profit here, not sales… Don’t get confused by calling the money coming in the door “profit” – it’s not, it is only money in the door….
Profit is what is left after making sales and paying your bills i.e. it is what you get to take home at the end of the day! So profit is a function of both the money you get in the door AND your costs.
For more about types of profit see
Income Statements Explained – Elements Mastered[/box] One of the main reasons costs are confusing is because often people, even accountants, will use the types of costs interchangeably with their behaviours.
This is kind of like mixing up colors and flavours when describing a food… If I say ‘this is a strawberry sweet’ do I mean it tastes like a strawberry or it is pink? It could be pink but taste lemony – see what I mean? People are careful to differentiate colors and flavours separately when describing lollies, and yet often I discover client’s decide not to even think about costs because it is “all too hard”.
Below is a very easy approach you can use to understand the behaviour of any type of cost.






No more excuses: Cost Behaviours Explained

A. Variable Costs

Variable costs are expenses which keep changing in proportion to the activities of a business – the more work the business does then the higher these costs will be. All Direct cots are variable costs, but not all variable costs are direct costs.
e.g. stationery needs are not consistent every month, some months may have a newsletter, others not much correspondence at all but the stationery costs for the month will align with the amounts of stationery used by the business.
 

B. Fixed Costs

Fixed costs are expenses which do not depend on the level of goods and services proffered by a business. These costs have a propensity to be time-related rather than volume related.
e.g quarterly maintenance contracts, or rent, or in many cases permanent staff salaries all are pretty fixed. Don’t get caught in the trap of thinking fixed costs NEVER change, they are simply fixed for a period of time – usually a year or so. Fixed Costs are never Direct costs, because they lack any direct correlation between their expenditure and any sales made or goods produced.
 

C. Mixed Costs

These costs as their name implies behave in both a fixed and variable way. The fixed fraction of the cost is the expense that needs to be paid regardless of the level of activity, this cost is going to incur anyway even if you manage to avoid the variable portion of this cost, the other fraction of the cost is based on usage.
e.g. Electricity costs are a good example of this, there is a fixed component you pay simply for having access to the utility to cover infrastructure etc, and also a portion depending on how much you use. In the case of electricity, at some point the more you use the cheaper the per unit costs becomes.
 

D. Marginal Costs

Marginal cost is the change in the total cost that arises when the quantity produced changes by one unit. That is, it is the cost of producing one more item. Marginal costs are the result of a calculation; not an actual spend on any particular product or service, but an aggregation of all production costs divided by the amount produced. – If you are a manufacture this calculation is important for deciding how and when to expand production capabilities.
Just for some added confusion/clarity – here is a table of examples:

Variable CostsFixed CostsMixed Costs
Direct CostsMaterials, StockNot PossibleDelivery of this month’s sales within a set radius = $500 but $10 extra for every 1km outside the delivery area/td>
Indirect CostsStationery, Advertising, TrainingReceptionist Salary, Rent, RatesTelephone, one part pays for infrastructure, lines etc, the rest is charged by the call

 

Have a Cost that you aren’t quite sure what it is and how it fits in, feel free to add it to the comments below and I will unravel that cost specifically…

 
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Do you want more profit?

Not sure where to start budgeting?? then try this template…
This very easy way to get started as it includes both budget table and a process to follow:

  • STEP 1 Gather your Budgeting Calculating Ingredients
  • STEP 2 Write down your Future Plans on the Strategy sheet
  • STEP 3 Sort out your Future Plans into Budget Headings on the Easy Budget Worksheet
  • STEP 4 Apply the dollars on the Easy Budget Worksheet
  • STEP 5 Do a Profitability Check using the pre-existing formulas in the Easy Budget Worksheet

 

FREE – Easy Budget Worksheet

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About the Author

Costs Explained Eve Blackall Smart Accounting
Eve Blackall the small business answer to The Supernanny.
At SMART ACCOUNTING you work one-on-one with Eve who has already assisted hundreds of business owners increase cash-flow, grow profits, plus ensuring those businesses fetch the highest price when it comes time to sell.[/box]