The Basics of Costs

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Fixed and Variable Costs and Formulas

Together, fixed and variable costs make up total cost.

In other words, total cost is equal to fixed costs plus variable costs.

The formula for calculating total cost is as follows:
 
TOTAL COST = FIXED COSTS + VARIABLE COSTS
 
The formula for calculating average total cost is as follows:
 
AVERAGE TOTAL COST OF PRODUCING 5 = TOTAL COST OF PRODUCING 5 UNITS / NUMBER OF UNITS
 
FIXED COSTS:

Fixed costs are business expenses that are not dependent on the level of production or sales. They tend to be time-related, such as salaries or rents being paid per month.

In accounting, these are the costs that do not change in proportion to the activity of a business.

For example, a business must pay its utility bills irrespective of how much it sells.

Depending on your type of business, some typical examples of fixed costs include rent, interest on debt, insurance, plant and equipment expenses, business licenses, and salary of permanent full-time workers.

The fixed costs are those costs that still occur when you produce nothing.
 
VARIABLE COSTS:

Variable costs, by comparison, do fluctuate in proportion to the activity of a business. These are costs that are volume-related.

In other words, if you didn’t make anything or sell anything, you wouldn’t incur these costs.

Variable costs are sometimes called unit-level costs as they vary with the number of units produced.

The variable cost is the sum of marginal costs. It can also be considered normal costs.

Along with fixed costs, variable costs make up the two components of total cost.

Unlike fixed costs, which remain constant regardless of output (how much you make or sell), variable costs are a direct function of production volume, rising whenever production expands and falling whenever it contracts. Variable costs will be different for different kinds of businesses.
 
EXAMPLES OF VARIABLE COSTS MIGHT INCLUDE:

  • Raw materials
  • Packaging
  • Labor directly involved in a company’s manufacturing process
  • Cost of goods sold
  • Sales commissions
  • Shipping charges
  • Delivery charges
  • Costs of direct materials or supplies
  • Wages of part-time or temporary employees
  • Sales or production bonuses

 
In retail the cost of goods is almost entirely a variable cost; this is not true of manufacturing where many fixed costs, such as depreciation, are included in the cost of goods.
 
The formula for calculating total variable cost is:
 
TOTAL VARIABLE COST = TOTAL QUANTITY OF OUTPUT * VARIABLE COST PER UNIT OF OUTPUT
 
The formula for calculating average variable cost is:
 
AVERAGE VARIABLE COST = TOTAL VARIABLE COSTS/NUMBER OF UNITS
 

Using Costs to determine Gross Profit Margin

Say Tom Smith Widget’s business has an order for 10,000 widgets for a price of $10,000.

Tom wants to calculate the gross profit from the order.

To do so, he must first calculate the cost per widget.

Let’s assume the following:

Annual Widgets Produced – 300,000
Raw Materials Costs – $20,000
Direct Labor Costs – $50,000

To calculate the variable costs we can add together the raw material cost with the direct labour cost:

$20,000/300,000 means each widget costs 6 cents each in raw material cost.
$50,000/300,000 means each widget incurs 17 cents each (rounded up) in direct labour costs.

Using this information, we can see that each widget costs 23 cents each.

10,000* ($0.06 + $0.17) = $2.300.

Based on a selling price of $10,000, Tom Smith expects to earn $7,700 ($10,000 – $2,300) gross profit from the order.

Contribution Margins

When you know the contribution of your product, you can make better decisions about whether or not to add product lines, how to price your products, or how to structure sales commissions.

The contribution margin is the percentage of each sales dollar that remains after the variable costs are subtracted and is relatively simple to calculate using a modified income statement:
 
Contribution-Margin
 
The same model can be used to calculate the contribution of different products.

This can be useful when it comes to comparing the performance (profitability) of the different products you have.

Let’s imagine Tom Smith makes red, blue and black widgets and wanted to understand the contribution margin of each. The model would look something like this:
 
Contribution-Margin-2
 
If there is a major discrepancy in the percentage contributions that a product is making, it may be a signal that your price is too low.
 
READ: More about pricing strategy.
 

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