Classifying business costs

All organisations have to manage a whole range of different costs from salaries to stationery, and cost control is an obvious requirement for any profitable company.

In order to do this we must first identify the types of costs faced by our business. These can be classified into two basic categories :

Fixed costs

These are costs which must be paid irrespective of the level of activity of the business, e.g. rent, light, heat, salaries etc. They are predominantly indirect costs because they do not directly relate to the level of production or revenue of an organisation. They can also, somewhat descriptively, be referred to as sunk costs.

Variable costs

These are costs which are directly related to the level of activity of the business e.g. raw materials, direct labour. They are predominantly direct costs and, in the simplest cases, will vary directly in proportion with production. That is, if the manufacturing level doubles the variable cost double.

There are, of course, some costs which do not readily fit in to one of the two categories, e.g. maintenance which tend to increase as production does but not in direct proportion, i.e. it is a semi-variable. Also fixed costs can change over time, if we buy a new machine or sell premises, although they remain fixed for a specific time period.

However the simple categorisation of two basic costs provides us with some powerful financial tools.

Charting fixed costs

If we were to chart the fixed costs of a manufacturing unit for all levels of production from zero to 100%, our line graph would look like this:

The fact is that as fixed costs do not change as production increases or decreases they are the same for any level of production. If we manufacture nothing over a holiday period, for example, we still have to pay the rent.

Charting variable costs

Similarly we can chart the variable cost of our business. The difference is that these cost do vary directly in proportion with the level of production and so our graph will look like this:

Charting total costs

On the assumption that we can categorise all business costs as either fixed or variable then the total cost of a business is the fixed costs + variable costs and this again can be graphed:

Charting revenue

Finally we can also add a revenue line to our graph which naturally begins at zero for no sales and increases proportionately in line with volume. Superimposed on the same scale as our cost graph it would look like this:

The break-even chart

It can be seen that there is a point on the graph at which  revenue = total cost  and this is therefore the break-even point, i.e. the level of business at which no profit or loss is made. Business below the break-even level does not recover all its costs and therefore makes a loss, business above that level generates revenue in excess of costs and therefore makes a profit.

We can identify the level of business in terms of either number of manufactured units on the volume scale or as level of sales on the £ revenue scale. On a graph it is easy to read off a rough figure:

Calculating the break even volume

A break even graph is a simple way to estimate a rough break even level, and we can also use them to investigate 'what if' scenarios e.g. what if costs increase, what if we raise our price etc.  But it may be the case that we want a more accurate measure and therefore need to make a mathematical calculation. An equation exists, which allows an accurate calculation of the break-even volume i.e. number of manufactured units, the origin of which is totally logical.

The following terms have been abbreviated for ease of presentation:

First we know that at the break-even volume:

In other words...

The company will break even when sales / output reach  2000 units.

Margin of safety

A final aspect of the use of break even calculations is that we can express the break even volume as a percentage of total capacity.

For example: a break even volume of  4,000 units for a manufacturing centre with a maximum capacity of 10,000 units  could be expressed as a break even of 40 %.

If our current level of production is 8,000 units i.e. 80% capacity,  It could be said that we can reduce production by 40% before we become lose making i.e. fall below break even levels.

In other words our  margin of safety is 40%  i.e. the gap between current levels of production and break-even levels is 40% of maximum capacity.

On a graph this would look like:

Conclusion

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