Understanding Costs

The cost structures of your firm are fundamental to its longevity. Understanding the link between more revenue and additional costs required (or the opposite), cost allocations, fixed or marginal costs has significant impact on profitability.

Understanding costs will make sure your business is spending in the right areas as costs are not only tide to profits of a stable business, they’re also tide to generating revenue to grow or maintain current levels. Below are some initial area relating costs to challenge your thoughts for your business.

Types of costs

When people think of costs, they generally lead towards Fixed Costs which are predominately linked to labour and the majority of overheads. Fixed costs are fixed for a known period of time and can only be broken with notice.

One of the biggest mistakes even accountants make is incorrectly allocating fixed direct and indirect costs to review a true reflection of the business to provide meaning.

Then you have Variable Costs. These are costs that increase or decrease with usage or outcomes. The majority of variable costs are related to costs such as direct costs (including labour or contractors), utilities or commissions.

Costs allocations

You will also need to consider costs allocations in your business, especially at internal reporting levels. This will help identify profitability or team business units, service/product lines and even the success of projects. To have effective costs allocations, first you need to identify the nature of costs and how they are assigned to each area of your business.

Potential consequences

Cost Type Action Potential Consequences
Fixed Costs Decrease

 

  • Decreasing fixed costs can lead to greater profitability if sales remain unchanged or if gross profit drops by less than the decline in fixed costs.
  • Risk if those costs are needed to generate of revenue.
Increase
  • Increasing fixed costs can lead to greater profitability if sales increase through better service delivery by an amount which is sufficient to compensate for the increase in fixed costs
  • Risk if new revenue isn’t generated.
Variable Costs Decrease
  • Decreasing variable costs can be effective if the product or service quality is retained.
  • Risk if the service/quality levels drops and has consequential effect on sales
Increase
  • Improvement in product or service quality involves increasing variable costs but allows a higher price to be changed. This can improve profits if the price increase is both accepted by the market and sufficient to offset the higher variable cost.
  • Risk if the service or product cost increase is less than increase in revenue.

Economic principles

When applying economic principals to costs, there are a few key areas you need to understand. These are:

  • Profits are maximised when marginal costs equal marginal revenue
  • Shut down your business, business unit/service line or project when marginal and variable costs are equal
  • There is profit produced if price and quantity meet above average total costs

Note – Economic principals assume there is perfect competition and no other factors come into play i.e. knowledge, location, relationship value. You need to apply additional factors that concern your business.

Where do you start?

If you’re unsure of where to start in your business, then simply start with identifying your firm’s cost structures. Assign responsibilities around costs moving forward and understand your cost links before performing a current cost structure review.

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