Types of Business Costs Explained

cost graphEvery organisation has various daily costs and expenses that result from its trading activities. Some of these don't change over the short to medium term whilst others will increase or decrease directly as a result of production or sales changes.

A break-even analysis produces your break-even point which is a level of sales where just your fixed costs are covered. Any additional margins above this point start to produce profits and positive cash flow.

Fixed Costs

Definition: An expense or charge which doesn't change in value if one more unit of sales or production is undertaken.

The most obvious Profit and Loss items that are paid each month would include rent, rates and other utilities. These are the base line in a business that if zero sales were made each month would still need to be paid.

As you start to scale your operations and require larger premises or more staff then these foundation values will increase in steps. It's something to bear in mind when preparing future forecasts.

Examples of Costs That are Fixed

For standard operations the following will not change on a daily, monthly or quarterly basis apart from small inflationary increases over time.

  • Monthly rental payments
  • Local council business rates
  • Office premises electricity and gas
  • Salaries, pension and National Insurance contributions
  • Other utilities such as water and telephone line rental
  • Mortgage and loan repayments
  • Vehicle leasing and maintenance
  • Accounting and legal
  • Most marketing and advertising

Variable Costs

Definition: An expense that is accrued resulting from a sale or stock production.

Costs that vary when one additional sale or manufactured product is made are called variable costs. These mostly contribute to gross margin calculations and are directly related to generating stock or sales.

Variable Cost Examples

  • Staff salaries paid on a piece meal or time basis
  • Cost of goods sold or made
  • Raw materials for production
  • Travel, entertainment and hotels
  • Delivery and transportation
  • Sales commissions and bonuses

The above classifications will change depending on the industry of the business. For example an Accountant would have their mortgage payments as a fixed cost whereas a buy to let landlord would see these as variable.

Calculating Break-Even Points

Your break even point is where sales revenues less variable and fixed costs produce zero profit. The place in which the purple and green lines cross in the graphic below is this critical time. To the left of this the business makes a loss and to the right, with more sales, then profits are realised.

break even charge

Pricing and improving margins plays an important role in profitability. Although this analysis is mainly used in manufacturing organisations it's applicable to any almost any business that has unit pricing.

  • Accountants and Solicitors charge by the customer account
  • Restaurants are more profitable with more covers

To produce this type of analysis use your forecasting tools and project the average revenue value for each additional customer together with their direct costs to produce a margin. Multiply the margin by the number of sales you believe you'll make at various points to see the volume required to cover your fixed costs. At that point you are at break even.