Understanding Types of Costs in Business
- To run a bakery, you’ve rented a cozy space, hired staff, and stocked up on ingredients.
- Some expenses, like rent, stay the same no matter how many croissants you sell, while others, like ingredients, increase with production.
- Understanding the different types of costs: fixed, variable, direct, and indirect is essential for managing your finances and making informed decisions.
Costs
A cost refers to the expenditure a business incurs while producing goods or services. Typical costs include payments for raw materials, wages, rent, and fuel.
Set-up Costs vs. Running Costs
Set Up Costs
The initial expenses incurred when starting a business, such as purchasing equipment, legal fees, and branding costs.
Examples of Set-up Costs
- Purchasing equipment and machinery
- Software setup and IT infrastructure
- Legal fees (e.g., business registration, permits)
- Employee training for new processes
Running Costs
The ongoing expenses required to operate a business, including salaries, rent, utilities, and maintenance.
- Running costs, also known as operating costs, are the ongoing expenses required to maintain day-to-day business operations.
Examples of Running Costs
- Salaries and wages for employees
- Rent and utilities (electricity, water, internet)
- Raw materials and supplies
- Maintenance and repair expenses
"Costs" refer to expenses incurred to produce goods or services, while "price" is the selling price that includes profit.
Exam technique- Avoid circular definitions.
- For instance, don’t write, “Set-up costs are costs for setting up a business.” Clearly define terms with examples to gain marks.
Fixed Costs: Expenses That Don’t Change with Output
Fixed costs
Fixed costs remain constant, regardless of production levels.
- They do not vary but become more efficient when spread over higher production volumes.
- This is called economies of scale.
Examples of Fixed Costs
- Rent: Lease payments for premises stay constant, no matter how much you produce.
- Salaries: Managers earning a fixed monthly wage.
- Insurance: Property or liability insurance premiums.
- Loan Repayments: Monthly interest payments on loans.
A drone manufacturer incurs €5 million in fixed costs annually, whether it produces 10,000 or 70,000 drones.
Exam technique- For cost calculations, mention that fixed costs do not change with output.
- This distinguishes them from variable costs.
Variable Costs: Expenses That Fluctuate with Production
Variable costs
Variable costs change in proportion to the level of output.
- Following the idea of economies of scale, this also applies to purchasing economies of scale, where as output grows, businesses can negotiate better deals on materials.
