Costs

Costs are the direct or indirect expenses that a business incurs in order to carry out activities that earn revenue, such as manufacturing goods or providing a service.

How it works

There are two main ways of classifying costs: direct, or variable, costs, which increase as more goods and services are sold, and indirect costs, which contribute to the overall running of the business and can either vary with the level of production or stay fixed. There are three main costs that businesses need to account for. The first is labor—wages paid to people employed to carry out a particular task. Labor can be regarded as direct or variable, or as a fixed cost or overhead. The second is the raw materials used in production and other materials used in service industries—these costs are variable. The third is expenses, which are other costs incurred in the course of the business’s activities.

NEED TO KNOW

• ❯ Break-even point (BEP) The point at which total sales revenue is equal to total costs
• ❯ Questionable costs Costs that can be treated as fixed or variable
  ❯ Sunk costs Costs incurred in the past that cannot be recovered
• ❯ Prospective costs Costs that may be incurred in the future depending on which business decisions are made

Fixed and variable costs

One way of looking at costs is to split them into two categories: fixed costs, which do not change with the level of business activity, and variable costs, which do change with the level of business activity. This helps accountants to determine how changes in business activity (for example, cutting or increasing production) will affect costs. In reality, some fixed costs will increase once business activity reaches a certain level—these are called stepped fixed costs.

Fixed costs

• RENT AND INSURANCE COSTS
• LAUNDRY SERVICES
• STAFF SALARIES
• CLEANING BILL

A restaurant rents premises to cater for 40 diners. The fixed costs are the same whether the restaurant serves 30 or 40 diners a night.

Stepped fixed costs

• HIGHER RENT AND INSURANCE COSTS
• EXTRA LAUNDRY SERVICES
• HIGHER STAFF COSTS
• HIGHER CLEANING BILL

The restaurant becomes popular, so the owner rents the premises next door to serve an additional 40 diners a night. The costs that were fixed at a certain level have now doubled.

Variable costs

The head chef orders the ingredients that will be required each day. For peak evenings the cost of the food order is higher; for quieter nights, the food order is lower.

• LARGE FOOD ORDER
• PEAK EVENINGS
• QUIETER EVENINGS
• SMALL FOOD ORDER

40%
of business owners say that payroll is their greatest expense