The main objective of any business is to prosper and reach economic growth. To achieve an increase in profitability there must be an appropriate cost control. There are different types of costs and we will explain the difference as it is key.
Fixed vs. Varible Costs
Fixed costs are “expenses” that we must assume, whether we produce a single product/service unit or X number of units (depending on the production capacity). Once such capacity is reached, a new fixed costs threshold must be determined. This explains why the general idea that long-term fixed costs don’t exist.
One of their main characteristics is their periodicity, as they can be frequently repeated and become monthly, quarterly, etc. Some of the most common examples are rent, insurance and indirect labor. Additionally, these costs must be distributed among each sold unit in order to determine its production value, while keeping in mind the ratio of the business’s volume and size.
On the other hand, we have the variable costs, which allow greater flexibility and, therefore, better adaptability. These are directly linked to the production volume. The most significant are listed below:
Raw material or merchandise.
Indirect production costs: every other type of assets (indirect material, input material, tools, etc.) and services, ad hoc taxes, etc. that are consumable or related to production.
Although, variable costs offer companies greater flexibility, the company cannot aim to incur certain costs that surpass the corresponding break even point. A company with more variable costs than fixed costs will always have higher profitability.
Other Cost Classification Methods
Another equally important way of assessing the company’s costs is the classification of direct and indirect costs. Direct costs are related to the asset’s or service’s production process activity. These can be easily identified since, without them, the asset or service would not exist. Moreover, they do not need distribution rules. Indirect costs, on the other hand, are related to the financial periods and require to be designated by means of a distribution method.
Among the different systems applied to allocate costs we can find the method of “sections”, by which a primary distribution classifies and identifies costs according to their nature. Subsequently, these are allocated to the different cost centers: primary and service. A secondary distribution that does take into consideration the cost centers is then carried out.
A different method applied is the direct method, which can be useful when the “service” centers’ costs are directly assigned to the production centers.
Benefits of a proper costs type analysis
Analyzing the different types of costs and the importance of efficient managing will help to guarantee the product’s/service’s competitiveness in the market and can also indicate whether our selling price is consistent or not with the company’s cost structure.
Furthermore, it allows you to analyze business profitability, contribution and gross margins and also to analyze Earnings Before Interest and Taxes (EBIT). These results along with Cash Flow provide the ultimate measure of the company’s financial standing.
The contribution margin can be obtained by subtracting the variable costs from the sales revenues. The final result corresponds to the units that allow the company to meet all fixed costs. The first answer provides revenue results, while the gross margin gives a comparison between the profitability of two or more business or product lines.
At this stage, understanding the concept behind the Break Even Point becomes key: it is the balance between the production and/or sales volume needed to cover 100% of the fixed costs and the point above which benefit can be obtained.
Here is the formula!
In order to make an overall assessment of all these concepts, we will analyze a local example such as the production of Manchego cheese in Spain. The region where this is mainly produce, called “La Mancha” is well known for its cheese, wine, saffron and an endless list of delicacies. When it comes to cheese, sheep milk with designation of origin would be the star of the area, topped off with a touch of olive oil that may vary according to the cheese being produced.
The elements needed to produce a cheese that will weigh less than 1.5kg will cost €50. Let’s imagine a legendary cheesemaker holding ancient secrets to the production of cheese, in a hidden spot of La Mancha, rents an enabled villa for €20,000 a month in order to produce cheese. The equipment needed for the latter has a monthly depreciation of €4,600. Total fixed costs equal €24,600 while he sells each unit of cheese with certification of origin for €80.
Notes: if the selling price for each cheese is €80 and the variable cost for each unit is €50, this means that each unit of cheese sold contributes €30 to cover the fixed costs and the business’s operational funds. When applying this formula to find the break even point, we get the following results:
When replacing the values of the example used, we get the following:
BE = 24.600 / (80-50) = 820 units
Those 820 units would correspond to the number of units of cheese that should be sold to cover operating costs. Beyond that point, profit can be obtained.
How to Minimize the Fixed Costs
The lack of analysis of fixed costs will reduce business’s flexibility to the point of making it plunge or vulnerable to competition and slows down the changes that promote innovation which leads to success and profit.
Considering all this, we learn that reducing such type of costs has become a need to guarantee the company’s viability. To this effect, an interesting method is to outsource some of the key company’s tasks to optimize operations and not part of the core structure.
In this respect, you can resort to outsourcing companies with experience in services such as legal, tax, labor, accounting, administrative structures, logistics, laboratory technicians, or material handling, as they may carry out such responsibilities at a lower cost, more efficiently.
Should you need more advice or outsourcing your back office, please don´t hesitate to ask clicking on the button attached.
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