Well “duh”, I can hear some of you sigh, “I know costs impact profit, so of course understanding them makes you more profitable”. Who TF is this Davina person and what on earth does she think they can teach me if they are stating this obvious sh*t.
Firstly, it's Davinia (can you spot the difference?)
And secondly - well, fair one. Because yes, you are correct: costs do directly impact profit because income minus costs = profit
But knowing costs and understanding costs are two very different things.
I want to ensure you *understand* the costs involved in your business, so you can better manage them and your business overall, as well as, of course, making sure you’re (more) profitable! #goals
And so this article should help you to *Un.Der.Stand* your business costs better. I want them to be your Best Financial Friend, something you embrace and enjoy spending time with on a regular basis, not just a casual acquaintance you see for lunch every quarter.
Sooooo, here goes.
The things we need to acknowledge to begin with:
Not all costs behave in the same way
Costs can be grouped in different ways
As a starting point we need to look at how costs behave - and no, I’m not talking about how rude or polite they are (although yes, costs are freaking rude, I mean how very dare they take some of my revenue… Oh wait, I had a point, sorry) we are interested in how costs behave - i.e. how they change (or not) as our business changes. If we understand how they change, we can make some plans - like how much to make so we can earn a profit!
Want more insight into the accounting and finance terms I'm using in this article? Check out my other post "Essential financial terms for every business owner"
So how do my cost behave?
It’s going to depend on the type of cost they are.
“There are two types of people in this world:
Those who can extrapolate from incomplete data...”
Did you get it? I love a #nerdjoke - Sorry (not sorry). Right, back to the point... types of costs! There are different types of costs and yes, they behave differently... For our first grouping of costs:
No matter what vs. sometimes costs
Fixed costs are the ones that do not change with the amount you produce / sell and so you pay the same no matter how much, or how little, you sell. This is why we generally call them ‘fixed’ costs in accounting.
They are (generally) unavoidable, which means they are paid whether you sell anything or not. They are what we can refer to as ‘no matter what’ costs. Because we pay them. No. Matter. What.
Examples for most businesses would be: rental for your shop or office, or expenses such as insurance, annual registration fees and wages of permanent staff (including yourself!). Fixed loan repayments or similar obligations would also be included in this category.
These are all commitments that we have to pay no matter what, so we have to ensure we are making enough to cover these!
Your business will also have some costs that are ‘sometimes’ costs - these costs I call ‘sometimes’ because they will change, or at least vary to some extent, over the short term - in accounting we call these variable costs! (Yah, I know, we’re not hugely imaginative in naming! “Say what you see” lol).
Variable costs can change directly in relation to the number of units you make (e.g. the ingredients to make a cake) or less directly (e.g. electricity for your premises - will be higher when you bake more, but harder to connect the amount to specific extra cakes made), and it is this relationship between the cost and the cakes (units) that we want to look at in a bit more detail.
So for the second distinction of types of costs:
Direct vs. Indirect costs
Direct costs are those directly associated with a single unit of product or service: like the ingredients used to make a cake I mentioned before (to make 1 cake needs 1 egg, 2 cakes would need 2 eggs… ok ok I’m not a master baker (lol) ok?? But hopefully you get the idea)
Indirect costs are those not directly associated with a single unit (or individual cake): for example the electricity for the oven or the cost of the oven itself
>> Sometimes people talk about ‘overheads’ which, strictly speaking, could include fixed costs or variable costs. What they are (normally) referring to are any type of indirect cost - i.e. those that are not associated with the production of a specific individual unit.
Direct costs are always going to be variable - because the more or less you make will impact the total value of these costs.
Indirect costs can be fixed (e.g. rent) or variable (e.g. utilities or facebook ad spending).
The challenge for many businesses is that to work out your selling price, cost is normally the starting point (we want to sell the item for more than it costs us!). Potentially easy with a resale business - just add a percentage or fixed amount onto the cost of each unit. It can also be straightforward with a production business - add together all the different components and then add a bit on.
However, as a business, you need to earn enough revenue to cover both the direct and indirect costs, otherwise overall you will not be profitable. Many new businesses don’t properly account for their indirect costs, meaning they are not correctly calculating their prices or their profit! Quelle horreur!!
Where we incur costs
You can also split up your costs based on where they are incurred - i.e. whether in the making of your product (production costs) or separate to, often after, the making (non-production costs).
Let me give you another example.
If your business is making jewellery, big-ass shiny crystal jewellery, then the metal, the stones, the fixings (the materials) and the time needed to put them together (the labour) are production costs. They are incurred to make (i.e. produce!) the product you want to sell.
Whereas website fees, etsy commission, costs of delivery to customers are all incurred separately to the making of the item, so are non-production costs.
This split is most relevant to businesses with physical products, if you have a service based business then a production / non-production split may not be as helpful.
Sometimes a business will further split their costs by type of cost, e.g. materials costs, labour costs etc.
Ultimately, the way to classify (group / organise) your costs will depend on your business, and there are many different ways to do it. What is most important is that you know what costs are being incurred by your business, and how they change, so that you can ensure you are covering them all!
So how are you going to classify your costs? Are there any costs you hadn’t thought about including previously? Not sure what type of cost something is? Get in touch and let me know!