Different Types of Costs

Different Types of Business Costs

Different types of business costs

• Businesses incur a range of costs 

  • Examples include purchasing raw materials, paying staff salaries/wages and paying utility bills such as electricity 

• These costs can be classified as follows

  • Fixed costs

  • Variable costs

  • Total costs

  • Average costs

1. Fixed costs

• Fixed costs (FC) are costs that do not change as the level of output changes

  • These have to be paid whether the output is zero or 5000 

  • Examples include rent, management salaries, insurance and bank loan repayments

• Fixed costs can be plotted on a graph as a horizontal line

• The fixed costs for this firm are $4,000 at all levels of output

2. Variable costs

• Variable costs (VC) are costs that change directly with the output

  • These increase as output increases and vice versa

  • Examples include raw material costs and wages of workers directly involved in the production

• Variable costs are plotted on a graph as an upwards sloping line, starting at 0

3. Total costs

• The total cost is the sum of the variable and fixed costs

• The total costs cannot be 0, as all firms have some level of fixed costs

• Total costs are plotted on a graph as an upwards sloping line, parallel to the variable costs, starting at the level of fixed costs

4. Average costs

• As a firm grows, it is able to increase its scale of output generating efficiencies that lower its average total costs (AC) of production

• These efficiencies are called economies of scale 

• As a firm continues increasing its scale of output, it will reach a point where its average total costs (AC) will start to increase

• The reasons for the increase in the average costs are called diseconomies of scale

Cost calculations

•  Based on the above definitions, we can calculate several different types of costs

1. Total costs

• Total costs are calculated using the following formula:

$\mathrm{Total} \mathrm{costs} \left(\mathrm{TC}\right) = \mathrm{Total} \mathrm{fixed} \mathrm{costs} \left(\mathrm{TFC}\right) + \mathrm{Total} \mathrm{variable} \mathrm{costs} \left(\mathrm{TVC}\right)$

2. Total variable costs

• Total variable costs are calculated using the following formula:

$\mathrm{Total} \mathrm{variable} \mathrm{cost} \left(\mathrm{TVC}\right) = \mathrm{Variable} \mathrm{cost} \left(\mathrm{VC}\right) \times \mathrm{Quantity} \left(\mathrm{Q}\right)$
      

Cost Calculations Using the Above Formulas Where FC is $200 and VC is $60 per unit

Using cost data to make Decisions

Using cost data to make decisions

• Businesses can use cost data to make data-driven business decisions

1. To reduce costs

• Accurate cost data can help a business identify if their costs are too high

• An important way to improve profit is to reduce costs

  • Fixed costs may be reduced by relocating to cheaper business premises, reducing salaries for workers, spending less on promotional activities or seeking lower-priced utility providers

  • Variable costs may be reduced by sourcing cheaper materials, buying raw materials in bulk, or outsourcing distribution to a third party business 

    • E.g., Many businesses sell their products using Amazon which manages the packaging and shipping of items, usually at a cost much lower than the business itself could achieve

• Businesses must carefully consider the impacts of reducing costs on customer service, quality and speed of delivery

  • Paying lower salaries to staff may mean that employees have fewer customer service skills or experience

  • Cheaper raw materials and components may lead to worsening quality

2. To set prices

• Costs play an important role in the determination of selling prices

  • They are a crucial part of making, or increasing profit

  • E.g., If the average cost of making a cake is $3 and the business wants to make $1 profit on each cake sold, it will need to charge a price of $4

3. To make production decisions

• If the cost of producing a product is higher than the revenue it generates, the business will make a loss

  • It will need to decide whether to continue making the product or stop

• This decision depends on various factors including

  • Whether the product has just been launched on the market, in which case the sales revenue may increase in future

  • Whether the fixed costs will still have to be paid

4. To make location decisions

• Property rental or the purchase of premises can be a substantial monthly cost

• Some locations are cheaper than others

  • A business must weigh up the cost of the location against other important factors such as transport links, proximity to customers and availability of a workforce