Understand The Cost

Written by Joe Driscoll

November 22, 2009

“There is a great difference between knowing and understanding: you can know a lot about something and not really understand it.”
Charles F. Kettering

The difficulty encountered in forecasting future revenues is often a major stumbling block in the decision making process. But revenues are only one part of the simple equation that measures business success. Getting a good handle on the other part of the equation, the expenses, is easier, equally important and frequently overlooked.

Developing a professional understanding of your costs and expenses, while it won’t help you predict the future, it will give you the means to manage these items, establish necessary revenue objectives and to better understand the relationships between expenses and revenues. Begin by defining each of your various expenses as fixed or variable, understanding the concepts of marginal contribution and operating leverage and then calculate your break-even point.

The process of classifying these expenses is not nearly as complicated as it may seem. Once you have established these definitions you will have an understanding of how these individual cost items will react as the volume of activity changes in your business.

The relationship of changes in an expense item and changes in the volume of activity result in the categorization of fixed and variable costs. Fixed expenses are those which are related to the passage of time and not related to the changing levels of business activity.

Those items which you have committed yourself to for at least the next year in order to run the business in a normal manner are fixed expenses. Items such as rent, depreciation, insurance, taxes and salaries are properly defined as fixed expenses. Fixed expenses will be expressed in absolute dollar terms.

Those items that will fluctuate in close relationship to the variations in business activity are variable expenses. When the activity of any particular volume measure such as units sold, units produced or dollars sold increases, the amount of a variable expense item will increase proportionately. When the volume decreases, the expense item decreases. Expenses such as manufacturing supplies, raw materials and sales commissions are all variable expenses.  Variable expenses should be quantified and expressed as so much money per unit of output. For example, raw materials cost $2.50 per unit or labor costs $.34 for each dollar of sales.

It is about at this time that a gray area known as semifixed or semivariable expenses arises to paralyze the process with confusion. Remember two things, first this is your business that you are dealing with and not some abstract example in an accounting book, and secondly you will not be judged by the perfection of the process but rather by the decisions that you make as a result of the process.

Don’t get hung up on perfecting the definitions of fixed and variable. Most will be quite obvious. If you are locked into the expense for the better part of a year regardless of what happens to sales, it’s fixed. The rest are variable so long as you can identify there cost per unit of volume.

In business, your exposure to risk is a function in part to the extent to which a firm’s costs are fixed. If your fixed costs are high, a small decline in sales can lead to a large decline in profits. Therefore, all other things remaining the same, the higher a firm’s fixed costs, the greater its risks.

The extent to which a business uses fixed costs in its operating structure is called operating leverage. With a high degree of operating leverage, a business has great risk but has a greater opportunity for reward in that a small increase in sales will result in a large increase in earnings.

Marginal contribution is the contribution which a sale makes toward covering your fixed expenses. If a product sells for $1.00 and the variable costs associated with it are $.60, each sale makes a contribution of $.40 towards the company’s fixed cost.

An understanding of the behavior of the cost structure is indispensable for making major decisions. The potential profit from new activities can easily be projected by comparing variable costs and anticipated revenues.

The concept of contribution margin forms the basis for calculating your break-even point. With your expenses properly classified, the formula is as follows. The break-even point in sales dollars “S” is equal to the sum of the fixed costs “FC” plus the variable cost per dollar “VC” times sales “S”. Expressed as a formula it looks like this, S = FC + VC(S).

You know your costs. Because it’s your business, make sure that you understand them and use that understanding in the decision making process.

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