Costs Are Just Costs, Right? Wrong!

I doubt that you like costs but understanding them is important. They can be viewed in several ways. For example:

• Direct and indirect. Direct costs are the costs of producing the business’s products or services and may include the costs of people, materials and direct overheads. Indirect costs are incurred in supporting the business, such as marketing, administration, IT and many others. This split allows calculation of gross profit – the profitability of the products or services – separate from EBIT (Earnings Before Interest & Tax), the profitability of the operating business, enabling you to pinpoint issues more easily.

• Fixed and variable. At the current level of operations, fixed costs don’t vary much with sales volumes, variable costs do. Beware fixed costs if sales are decreasing because they won’t reduce likewise, so profitability can plummet rapidly. On the other hand, if sales are increasing, fixed costs remain the same so profitability accelerates.

• Marginal costs (the extra cost of producing one more unit) and average costs (total costs divided by sales volumes). Providing additional sales revenue exceeds marginal cost, it’s worth producing one more unit but do that for all your products and you’ll go broke!

Understanding the nature of your costs enables you to make better decisions.

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