Whether you’re running your own business or analyzing the markets, understanding how changes in production and purchase volumes can affect costs is an essential part of your profit maximizing tool belt. Otherwise known as cost behavior, it will help you accurately assess the best option for your bottom line. This article will give you a better understanding of many of the different types of costs and how they can change.
If you’d like to skip the small talk and jump straight into actionable insights for saving money on costs, this course will serve as an excellent way to get started.
Some costs may be referred to as fixed, meaning they don’t fluctuate with changes in activity. Regardless of how many products are sold or produced, the same flat rate still applies. Only the cost per unit will rise or fall with changes in volume. A good example of a fixed cost would be rent, where a factory costs a certain amount every month and doesn’t increase with more activity.
There is a catch, however. Most fixed costs are tied to a relevant range. Sticking with our factory rent example, one factory will only be able to handle so much volume before another factory needs to be bought or rented. The number of units a single factory can produce will represent your relevant range and fixed costs will increase once you surpass it.
Other costs will vary greatly when more units are sold or produced. These are referred to as variable costs. Just a single unit more is enough to cause an increase. Material costs and commissions are examples of variable costs. Each unit produced will require more materials, thus raising costs. More product sold will automatically show itself in higher sales commissions. For a more in-depth look at activity based costing, make sure to check out this great blog post.
When a cost shows both fixed and variable characteristics, we call it a mixed cost. This goes back to what we said about relevant range, as the variable cost elements usually kick in after it’s surpassed. You cell phone bill is a great example of this.
For instance, say you pay $20 a month for 1000 minutes. This is your fixed cost. But once you surpass the initial minute allowance, you pay for each extra minute used at a higher rate – let’s say .05 cents per minute. That is where your variable costs come into effect. Combined, they represent a mixed cost.
Direct Costs vs. Indirect Costs
Expenses that are measurable in their contributions to a project are known as direct costs. Material costs usually fit into this category because you can link them directly to unit production. There’s no argument about whether they affect your bottom line. Because they’re so closely related to the business’s output, direct costs are often considered variable costs as well.
The opposite would be indirect costs. These are expenses whose relationship to production is a little more vague and harder to prove. They may also affect several different areas of the business. Something like insurance is a good example of indirect costs, since you’d be hard pressed to show exact numbers to back up exactly how having insurance impacts production directly. Indirect costs are often fixed costs that don’t change much with variances in activity.
You’ll often see expense reports broken down into direct and indirect.
An opportunity cost comes into play when you pass up one option in favor of another. It’s not always as tangible as the other expenses we’ve talked about and it’s usually not even directly recorded, but you should definitely keep it in mind when making important decisions in business or life. For example, say you’re choosing between two different jobs. You pass on the higher paying position in favor of a less lucrative spot because you like the company better. The pay you missed out on would be an opportunity cost.
Opportunity costs can be implicit or explicit when it comes to production. Check out this helpful course for even more detailed info on the numbers behind your budget.
When you buy a piece of production equipment, this represents a committed cost. That equipment will hopefully last you over a long period of time. Plus, it’s nearly impossible to cut the expense without sacrificing your business goals. In this case, your only option would be to sell or rent the equipment, which would greatly decrease your company’s production capabilities.
Some expenses are already lost forever and there’s no hope of recovering them. In this case, they’re referred to as sunk costs — we can’t alter them with our current choices. Say you’ve started construction on a new branch for your growing business. Once it’s begun being built, there’s no chance of getting all of your funds back. At this point, your only options are cutting your losses or continuing with the project in the hopes that your investment pays off in the future.
These are costs that aren’t necessary to your business’s functioning. Discretionary costs can be slashed as a way of saving money without drastically impacting your production volumes. This may include things like a larger per diem or daily allowance being granted to employees — it may boost morale and satisfaction but it can be axed from the budget with minimal major repercussions.
Applying What You Know
You should now have a very basic understanding of some of the different types of expenses you’ll run into regularly when managing a business or any other type of venture. The trick is expanding and applying your new found knowledge to make a tangible improvement on the way your business operates and makes money. Here’s a great course which will give you even more info about controlling costs as a construction project manager. Or if you’re more of an entrepreneur, this course will teach you how to build your business while minimizing costs across the board.