When you run a small business, cost behavior impacts how you price your products due to changes in sales volume or production. When your sales volume and production stay stable, this means your cost behavior remains in a relevant range, a term that refers to expense and revenue patterns that remain right where you expect them to stay.
Cost behaviors break down into four different expense classifications:
- Variable costs
- Fixed costs
- Step costs
- Mixed costs
Though you can use these classifications to analyze cost behaviors internally for any business, they work particularly well when you operate a business that manufactures products for resale, as they help you factor in behind-the-scenes costs that affect your bottom line.
So what are these four cost behavior classifications exactly?
1. Variable costs
Variable costs change as the number of products you produce changes. Imagine your small business crochets blankets. If you need to make more blankets, you must purchase more yarn. In this instance, yarn represents a variable cost because its final total cost fluctuates depending on many blankets you produce. Because you can easily control variable costs, you can slow or stop blanket production to reduce expenses when you reach the end of your relevant range or the amount of blankets you typically make. In some cases, though, making products beyond the relevant range drives your price per unit down. For example, this might occur if suppliers offer you yarn discounts when you purchase larger quantities.
2. Fixed costs
Fixed costs include things such as rent, insurance, salaries, and property taxes, which stay constant in your relative range. In some instances, though, expanding your inventory can drive up these costs. For example, say your crochet company has one warehouse to store its finished blankets and the rent on the warehouse costs $500 per month. By paying a fixed cost of $500 per month, you have the space to store a set number of blankets. If you need greater space, your fixed cost of rent may increase.
3. Step costs
When your fixed costs change at certain points, they’re considered step costs. To clarify, imagine you need more space for your blankets than your warehouse rental can hold. To accommodate your extra production, you rent more space for an additional $500. This takes your fixed costs beyond the relevant range and into the category of step costs, as the change in the way you do business creates extra expenses.
4. Mixed costs
Mixed costs refer to expenses that include both fixed and variable costs. Typically, mixed costs arise when your small business incurs a fixed flat charge plus an additional activity-based fee. Say your crochet company has a contract with a shipping company to transport its blankets. For this service, you pay a fixed cost of $75 per month plus a variable cost of $5 for every shipment you send, regardless of how many packages you submit for transport to customers. This means your crochet company incurs mixed costs for delivery of its blankets.
Usefulness of cost classifications
By tracking variable, fixed, step, and mixed costs, you get a clear picture of how your costs typically behave, which helps you when it comes to figuring out per-unit pricing. Because you measure these costs internally and log them as expenses, you build cost behavior into your pricing standards behind the scenes. This ensures you know how much you need to make per unit to break even and make a profit. Having this information on hand especially helps when you wish to expand your operations.
To measure cost behavior patterns, you first need to track and categorize your expenses into classifications and then look for your relevant range, or the spot where revenue and expenses balance exactly as you expect. Accounting software such as QuickBooks Online makes it simple to track and record cost behavior classifications along with every aspect of your small business’s financial life. More than 4.3 million customers use QuickBooks to manage their finances. Join them today to help your business thrive for free.