Business costs and how to manage them
Costs, revenues, and consequent profits are perhaps the three most important metrics in small business accounting. When costs are properly managed, a small business can sit above break-even point; finding itself with adequate cash flow to maintain its operations or pursue a new business endeavour.
General business costs can be anything from paying employee wages to purchasing stock, but truly understanding costs goes far beyond simply quantifying it and noting its size. In fact, there are a range of popular types of costs known to experienced accountants and businesspersons alike that can make financial conversations easier.
What’s more, understanding these different categorisations can make interpreting the potential impact of each cost a little easier; allowing businesses to gauge how quickly the cost needs to be addressed, the risk associated with it, and how it factors into an accounting strategy.
So, in this guide we’ll be helping SME owners get to grips with business costs and how to manage them.
Types of costs for businesses
So, what are the common types of costs most SMEs incur? How do they differ, and why do these distinctions matter?
Fixed costs vs variable costs
Fixed costs don’t vary based on a business’ outputs, while variable costs do. Examples of fixed costs include salaries, rent, and depreciation, and these are often also described as overheads. You’ll find a lot of fixed costs associated with large-scale business operations, such as the manufacturing process.
Whether a company scales up or diminishes the volume of its production, fixed costs remain, well, fixed. They’re likely tied into a contractual agreement, which may refresh on an annual basis. Anything that doesn’t fall into this category can be described as a variable cost. The cost of materials and labour costs are perfect examples of this, given they naturally grow as a business boosts its sales to meet a rising demand.
These definitions are, to an extent, useful – especially in instances with a lot of variable costs, such as revenue models that are built around sales commissions. However, they don’t perfectly describe all types of expenditures. For example, a marketing business that uses desktop computers to conduct its operations may view purchasing those computers for staff as a fixed cost. But a PC-seller that specialises in the sale of desktops would treat them very differently, as they look to scale up production and increase that cost to meet demand.
The total costs a business incurs is best considered in relation to the volume of produce. So, if a business generates a large revenue from sales and increase its variable costs, the same fixed costs now cover a larger amount of products created – driving down cost per unit.
Another helpful view of costs is to understand where in the product life cycle costs occur. A helpful distinction to make, then, is:
Direct vs indirect costs
‘Direct costs’ are related to the production of goods or services. There’s some overlap here with the term ‘fixed’ as typical examples include raw materials, labour, and the likes.
On the other hand, ‘indirect costs’ are classified as everything else – anything not directly related to the production of goods or services. To understand this, think of the cost of utilities incurred by a factory. You can’t trace the cost of utilities back to any individual product, rather it’s a blanket cost that covers the general operation. This distinction can be handy in discussions around profitability, where you want to segment your costs to focus directly on those relevant to production, and it may feature within your cash flow forecast.
Beyond these two popular cost distinctions, more advanced and technical definitions include:
This type of cost is often useful to investors to assess a business’ potential profitability. It identifies how many costs are incurred by the day-to-day running of a business, and can include both fixed and variable costs. An investor may compare your operating costs to your sales data, to get an idea of whether running costs are translating into sales.
This cost definition can be used as a decision-making tool to help identify the cost of choosing one business strategy over another. While it won’t feature in a financial statement, calculating an opportunity cost can help you get an idea of how much profit you could generate by, for example, choosing to work with one new supplier over another – all costs and projections considered.
When a business is contractually committed to affording a certain cost, and it therefore becomes inevitable, that cost can be described as a sunk cost. Flagging sunk costs can help improve financial planning, as business leaders can quickly move from determining whether to negotiate or navigate a sunk cost, to focusing on how to source funds and whether any variable costs are likely to be incurred by impending sunk costs.
Why does categorising your costs matter?
Due to the complex nature of each business’ finances, and the subsequent accounting processes required, there are a lot of different ways of interpreting data. Categorising costs and understanding both the meaning and relevance of those labels within financial conversations can make it easier to talk finance with prospective investors, business partners, and external lenders.
Each of these entities will likely have a different set of priorities, and want to gauge both the risk and potential profitability associated with supporting your business in a number of different ways – so understanding the lingo can really open doors. But ultimately, as a business owner, having an in-depth understanding of your costs and how they break down can help you make efficiencies and drive your company forward.
How could Rapid Cash help?
At NatWest Rapid Cash, we understand that your business’ ability to manage costs and maintain a healthy cash flow is vital to its success. That’s why we help thousands of small businesses overcome their cash flow challenges by offering a new type of invoice financing product that gives SMEs quick access to cash based on their unpaid invoices.
Our solution integrates with your accounting software to offer your business a line of credit. From there, you can choose which of your unpaid invoices you’d like to borrow against and receive the majority of the invoice value up front, which could empower you to seize growth opportunities. If you’re interested in learning more about Rapid Cash, read about how our solution works.
To be eligible for Rapid Cash you must be trading for more than 6 months, have an annual turnover of at least £100k and either be a Limited Company or Limited Liability Partnership in England and Wales. Additionally, you need to invoice other businesses and use one of the following digital accounting software: Xero, Quickbooks, Sage 50, Kashflow, FreeAgent and Netsuite.
Security and guarantee required. Product fees may apply.