Adrian Goodman, managing director of PPX Consulting, explains why correct classification of costs is crucial in order to accurately assess the performance of your business.
I FREQUENTLY ADVISE clients on the correct calculation of profit writes Adrian Goodman (above). This is a key component of effective performance evaluation and getting it wrong can skew your decision making and cause significant problems in your business.
There are two sides to this. The first is about timing. Making sure your costs and associated revenues are recognised in the same period is important, otherwise you will report higher profits in one period and lower in the next, purely because you’ve entered an invoice into the wrong period. This will affect your performance evaluation, which is the first element of control in your business.
The second variable in this equation is the classification of costs. Most business owners recognise the difference between variable and fixed costs (also known as Cost of Sales and Overheads, respectively) but they don’t always appreciate the consequences of mixing them up.
In truth, the terms ‘Fixed’ and ‘Variable’ are an over-simplification, because not all costs of sale are variable and notall overheads are fixed. It may help to break these down further as follows:
Variable These costs vary directly (usually proportionately) in line with sales revenue, because they are onlyincurred by manufacturing the product or providing the service. For example the raw material used in manufacturing a product.
Semi-variable These costs vary partially in line with sales revenue but also have a fixed element. For example,direct labour where an overtime premium is applied beyond a certain level of activity.
Stepped This describes a cost which remains fixed up to a point, changes once that point is surpassed, but isthen fixed at the new level, such as a software licence where the price is the same for up to 50 users, but then increases to a new price for 50-100 users.
Fixed Fixed costs are the same regardless of sales output. For example the rent on an office building, or a Director’s salary.
Variable costs are almost always a cost of sale, while fixed costs are almost always overheads. Semi-variable andstepped costs would normally be considered costs of sale and overheads, respectively, but in truth, both of these may stray between categories, based on the nature of the cost in the context of the operation. The general rule of thumb is to ask the question “Would this cost be incurred if there were no sales in the period?”. If the answer is ‘Yes’, then it’s an overhead. If not, it’s a cost of sale. If the answer is ‘Maybe’ or ‘Partially’ then you will need to apply judgement or seek advice.
But why does this matter? After all the net profit will be the same regardless.
That’s true, but understanding your gross profit (sales revenue minus cost of sales) is vital for accurate analysis of your business performance. Gross margin is one of the most important metrics in any business and informs yourmarginal contribution, breakeven point and ultimately, your economic viability. Putting your costs in the wrong place on your P&L can lead to incorrect assumptions, erratic decision-making and ultimately business failure.
Adrian Goodman is managing director of PPX Consulting
01536 856 740