In any economic environment, but especially in a tough one like today’s, companies must look carefully at their costs, not only to maximize their profits but sometimes just to make sure they stay in business. They need to have an accurate picture of where they could cut costs, where they might offer deals to drive sales and keep revenue up, and what products might not even be worth producing anymore.
Cost accounting or “costing” is a key tool to achieve those goals and many more. Detailed, accurate costing can provide valuable insights, but many business owners struggle to account for their costs or don’t fully understand the numbers their accountants or bookkeepers present to them in costing reports.
Let’s look at the three types of costs that are the basis of cost accounting – fixed, variable and semi-variable costs – to clearly explain what they are and how categorizing them helps inform and improve your business’s prospects.
WHAT IS COST ACCOUNTING?
Every business owner instinctively understands that the less it costs to produce and sell a product or service, the more profit they can generate. But any business of significant size will be awash in a sea of things like rent payments, invoices, packaging costs, loan payments, maintenance issues, insurance bills, sales receipts and wages, and it can be difficult to break down what it actually costs to keep the lights on and to turn the desired profit.
To overcome this problem, cost accounting breaks everything down into just two basic costs: fixed and variable. By doing this, we can get a clear picture of the nature of the costs involved in a business process, and therefore what options there are to control or improve them. One way to think of this is that it breaks costs down into a way we can “do the math” or “analyze the data” using formulas to focus on different aspects of a business process. Note that “semi-variable” costs aren’t specifically part of that picture – we’ll get to that.
WHAT ARE FIXED COSTS?
For practical purposes, we can think of fixed costs as the price of staying in business. Fixed costs do not change no matter how many sales are made. In a slump? Your fixed costs don’t change. Having a banner year? Your fixed costs don’t change.
Some examples of typical fixed costs would be:
Rent for administrative, production and storage space
Depreciation of equipment
Administrator or supervisor wages
Notice that we are not saying that fixed costs can’t change, just that they do not change based on your sales or production. In fact, one of the reasons for classifying fixed costs is to see if they are a drag on profitability and whether they could and should be changed.
WHAT ARE VARIABLE COSTS?
Variable costs do change when your business activity changes. The more you produce, and hopefully the more you sell, the higher your variable costs will be. You will sometimes see variable costs called “direct costs” because they can be directly related to the production of specific products rather than “indirect” costs that impact more than one product.
Some examples of variable costs include:
Raw materials for manufacturing
Food and beverage costs
SEMI-VARIABLE COSTS – THE CONFUSING ONES?
Semi-variable costs are composed of both fixed costs and variable costs. For example:
Salesperson base pay (fixed cost) + commission (variable cost)
Attorney retainer (fixed cost) + billable rate (variable cost)
Internet data fee (fixed cost) + overage fee (variable cost)
Business owners sometimes find semi-variable costs confusing since they are referenced as costs and yet often don’t appear in the final cost accounting, or even in blogs about costs!
Semi-variable costs must be considered because they are, well, costs. But at the same time, we can’t “do the math” on them until they are broken down into their fixed and variable attributes.
For example, to analyze how much of a product must be sold to reach a certain net income, we would use the formula:
Unit Volume to Achieve Target Net Income = (Fixed Costs + Target Net Income)/(Sales Revenue – Variable Costs)
“Semi-variable costs” are nowhere to be seen in this very useful analysis and are unlikely to be found in most other useful calculations. But they are still an important part of cost accounting. We need to classify them so we can break them down correctly into their fixed and variable components, and we also need to know them if we want to analyze those specific “mixed” costs and look for ways to minimize their impact on profitability. For example, we need to understand the semi-variable nature of paying a salesperson base plus commission, if we want to consider whether a change to a (fixed) salary or a (variable) full commission model might be better.
Detailed, accurate cost accounting should be a key part of every business’s managerial process. When you have a full understanding of your costs and their impact on your current and future profitability, you can effectively analyze those costs and make changes if needed in order to maximize your profitability and ensure your business’s survival and growth for years to come.