Costs are important to business because they:

• Are the thing that drains away the profits made by a business
• Are the difference between making a good and a poor profit margin
• Are the main cause of cash flow problems in business
• Change as the output or activity of a business changes

Fixed and Variable Costs

An important distinction needs to be made between variable and fixed costs.

Variable costs

Variable costs are costs which change as output varies.

Examples include:

• Raw materials
• Bought-in stocks
• Wages based on hours worked or amount produced Marketing costs based on sales (e.g. % commission)

Fixed costs

Fixed costs do not change in relation to output. They do change - but not as a consequence of output changing.

Examples include:

• Rent & rates
• Salaries
• Advertising
• Insurance, banking & legal fees
• Software Research and development

Calculating total costs

The total costs of a business can be calculated using this formula:

Total costs (TC) = Fixed costs (FC) + Variable costs (VC)

Let’s look at a simple example of how total costs can be calculated using the following example data:

What would Graham’s costs be in March if his forecasts prove correct?

Stage 1: calculate variable costs: = £75 x 100 = £7,500

Stage 2: add together the fixed costs = £2,500 (i.e. £500 + £1,500 + £100 + £400)

Stage 3: add variable to fixed costs: total costs are £10,000 (£7,500 + £2,500)

The costs incurred by a business are often relatively easy to estimate. You know how much salary someone is paid or what price your supplier is charging. However, this is not always the case – some costs are uncertain:

• Raw materials – affected by wastage
• Product returns or refunds – affected by quality
• Where a business or entrepreneur does not have detailed experience of a market