Seeing the Total Cost Picture - Part 1 of 2

Seeing the Total Cost Picture - Part 1 of 2
By: Daryl Cowie


There are only two ways to improve the overall profitability of your business: Bring in more money, and keep more of the money that you do bring in. When it comes to keeping more of the money that you bring in, cost control is the name of the game.

The first step in controlling your costs is understanding the different types of costs that your business has, and where all the money is going. It's important that you understand costs the same way your executive team understands costs so you can discuss and address them in ways that will be meaningful to them and to your business.

At the top levels of business all costs are classified as either fixed costs or variable costs.

Fixed Costs

Fixed costs are fairly simple to understand. These are things you need to pay regardless of how good or bad business is. These are things like your building lease and senior and strategic management team salaries. You need these things at a minimum to keep the doors open and the business moving.

It's important to understand that what is considered a fixed cost and what is considered a variable cost varies from company to company, and somewhat depends on what level of management you are looking at it from.

For example, to an office manager a photocopier and administrative team salaries may be considered fixed costs. To the CEO of General Motors, these may be variable costs dependant on how many offices they need to keep open, and whether or not they choose to consolidate services across departments to save money. You need these things to keep your office running. You may not need these things to keep General Motors running. It's a matter of perspective. From a practical management tips perspective if you can't control or influence it, consider it a fixed cost.

Whether or not a cost is fixed is also dependent on how long into the future you are planning. Over the long term all costs are variable, even buildings and senior management teams. In the short term it is advantageous to consider certain costs to be fixed. In general fixed and variable cost determinations are based on a 3 to 5 year vision.

Variable Costs

Variable costs differ from fixed costs in that they vary relative to the production of a particular product, or to the fulfillment of a particular service. In other words they are the costs associated with building things, providing services and fulfilling orders. They are referred to as variable costs because they vary relative to the amount of orders that you have. When sales go up you need to supply more of whatever it is you sell. As a direct result you need to purchase more of the raw materials and labor required to provide that and your variable costs go up. Conversely when sales go down, your variable costs go down.

To help understand and control cost, variable costs are normally broken down into direct costs and indirect costs.

Summary

In the executive and financial offices of your company all costs are categorized as either fixed costs or variable costs. The first step in helping the business manage those costs, is understanding what those costs are, and being able to talk about them using the same terminology as the accountants and executive leaders.

Put simply, fixed costs are things that you pay for regardless of how much you sell. Variable costs are things you only pay for as part of the cost of creating a product or delivering a service.

In part 2 we will discuss the next level of cost allocation: direct and indirect costs.


Daryl Cowie has shared management tips with 1000s of people in over 30 countries around the world. His mission is to help you and your company turn business opportunities into business realities. Sign up for his free business management home study course at FreeManagementTips.com