Better Small Business Control By Mastering The 3 Types Of Costs

In business, the basic idea is to lower costs, without sacrificing quality, and to keep doing so.

To achieve that goal, you must have a very good, clear understanding of costs. That starts by understanding the nature of the three types of costs. Strictly speaking, there are two types, fixed costs and variable costs. However, we find it beneficial to add a third type, overheads, to make it easier on our minds.

In economics, fixed costs are business expenses that are not dependent on the level of output produced by the business. This means that whether you make one hundred products or none at all, you will still have these costs. They tend to be related to time, such as salaries or rents being paid per month, and are often referred to as overhead costs. Reducing these helps you increase the net profit of the business as a whole.

This is in contrast to variable costs, which are related to the volume produced. These are paid per quantity produced. The more value you create, the more these costs rise. They include things such as raw materials, inventory, and so on. Reducing this helps you increase gross profit. Moreover, because these costs are tied to each unit of value created, reducing variable costs has a multiplier effect on profitability. For example, if you sell one thousand widgets a month, and you reduce the cost of making each widget by $1, you will have saved $1,000 a month. If you sell two thousand widgets the next month, you will have saved $2,000 that month.

And then there is overhead. Overhead is the total cost of keeping your business open at a minimum level of operation. It is how much you spend each month even if you don't sell anything at all. You could say it is your monthly fixed cost of keeping your business open. It includes items like rent, payroll, fixed utilities, and so on. Keep your overhead as low as possible and seek ways to keep reducing it. Lower overhead means less revenue needed to keep your business open. Lower overhead also means more flexibility in the sense that if you go through a rough time, you need less to stay afloat until that rough time passes.

The more familiar you are with your costs and their types, the more you will be able to control and optimize them and your entire business and produce more value at less costs.

Cut costs but never at the expense of quality, because when you reduce quality, you reduce value, and value is what gets you business.