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This podcast selection is taken from a series of Business Hub radio shows broadcast on Star FM between February 2011 and October 2014 with advice from basic book-keeping through to crowd funding, directors loans, cashflow and a whole lot more!

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Business Trouble - your choices

Different Types of Costs

The Business Hub Show - 26 February 2012

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The costs in your business come in all shapes and sizes and often work in many different ways. Not all costs then are the same!

Typically in any financial statements you see costs are grouped under headings which put them together logically. You might have a heading for say “premises” or “establishment” which would have analysed under it all the various cost types associated with your business premises, rent, rates, electricity, gas, etc.  Under a heading for Sales and Marketing you might have things like advertising, events, exhibitions, web site, etc.

This grouping makes it easy to understand the types of costs and the detail behind them.

However, today I wanted to look at costs in a different way, and that is by how they change over time or in response to other factors which influence them. Understanding this relationship with your costs is very important in ensuring that you don’t get any surprises and also how they may change when predicting the future in budgeting and the like.

Broadly there are three types: Direct Costs, Fixed Costs and Variable Costs. If you dig deep into technical accounting stuff you will find lots of our categories as well, but for now these three are probably the most useful to understand.

Direct Costs are those costs that can be directly associated with some form of activity. That might for instance be a sale. If you sell a widget then the cost of purchasing that widget would be described as a direct cost as it directly relates to that sale. In the same way if your business was engaged in a project of some description then the costs associated with that project would be a direct cost of it. Had the project not taken place then that cost would not have been incurred.

Variable Costs are those costs that change in proportion to something else, normally the activity of the business as a whole. So for instance the cost of your sales will vary directly in proportion to the sales you make. So if you make less sales you will incur less costs on the products that you have not sold. Some other variable costs are not quite so obvious, for instance if you are manufacturing widgets you might expect the cost of your raw materials to be variable, but so will be the electricity you use, and perhaps your transport costs, etc.

Fixed Costs on the other hand are as you would expect, fixed, but only over a defined period. As an example you might expect say your premises costs, or administration costs to be fixed. And that is likely to be the case in the short to medium term. However, if your business grows to such an extent that you outgrow your premises or you need another administration person then your fixed costs will take a step change to accommodate that.

So why is all this important?

It is critical that when reviewing your businesses performance that you have an understanding of the relationships of these cost types. If you appreciate what is fixed in the short to medium term you will not expect this to change much from one month to the next. A variable cost you would expect to move in proportion to the activity or sales. If it doesn’t then that warrants investigation to understand why. With Direct costs you will appreciate if an activity stops, say a particular project, that cost will also stop.

This understanding is also very important when forecasting and budgeting … as without this appreciation how can you possibly get your projections right!

Finally there may sometimes be an opportunity to change the characteristics of a cost to your advantage – say if you could fix a variable cost for a period when you know your activity is increasing.

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