What are variable or direct costs and what do they mean to your business?

Once you get involved in business finance, you cannot help but deal with both variable cost, and direct costs. Even before you start your business, when you are preparing your business plan and budget, you will have to account for both types of costs. This article will help you understand each type of cost and the difference between them.

Variable costs are costs that change based on the amount of business you are doing. The best example of variable cost comes from the manufacturing industry. If there is more demand for your product, you increase production. As you increase production, you need more raw materials to work with. These raw materials represent a cost (you have to pay for your stuff, right?) and that cost varies depending on how much of your product you are manufacturing.

While the manufacturing example is the one most often given for variable costs, there are plenty of other examples. If you have a delivery company and you pick up two new delivery accounts, you will need to purchase the gas to deliver to those accounts. In this case, the variable cost is gasoline. The good thing about variable costs is that you should be able to recoup all of your additional expenses through the additional work demands that you are meeting. However, it isn't easy to predict the bottom line when dealing with variable costs. Accountants and CEO get headaches looking at variable costs because the costs to return ratio is not usually linear and revenue is not easy to predict through standard regression.

If you deal with variable costs in your business, you will probably need some sort of financial advisor to help you understand some of the principles. For example, in most supply and demand relationships, there is a point of diminishing returns. You want to be able to determine at what point you stop making money and start loosing money (proportionally). Sometime taking on new business without changing current operating procedures can actually cost you. For example, at what point will you have to start paying overtime with the increased work load?

Direct costs are much more, er, direct. These costs might also be thought of as overhead costs. The terminology of "direct costs" is more closely associated with grants and grant writing than it is with business. In business, the distinction is generally between fixed and variable costs, with fixed cost being the same every month. Some costs seem to fall in the gray area between variable costs and fixed costs are things that vary but not necessarily as a result of increased business activity. Things like utilities may fluctuate according to the weather or the time of year rather than according to the amount of business that you have. Gas expenses, used earlier as an example of variable costs, might also be an example of fixed costs that vary. Gas prices go up and down independently of the amount of business you are engaged in.

When you are building a budget for your business, the fixed or direct costs will be fairly easy to handle. You know what certain expenses are, such as rent. The other fixed expenses you should be able to predict fairly well. When you are handling variable costs, you might make several different projections: one for a minimal amount of business, one for an average amount of business, and one for the maximum amount of business.
Variable costs can be tricky because you have to come up with the money to make the purchases. A sudden increase of business seems like a windfall, however, when you are scrambling to come up with the raw materials to meet the increased expenses it might seem like more of a nightmare.

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Tags: business business_finance variable_costs fixed_costs production manufacturing over_head direct_costs